May Day

It’s a new era

ERIK GORDON, ASSISTANT CLINICAL PROFESSOR AND ASSOCIATE DIRECTOR, ZELL LURIE INSTITUTE

May Day, 1975. The stock brokerage world changed forever. The SEC abolished fixed brokerage commissions, implementing a rule mandated by a Congress intent on reforming the brokerage industry.

Today, Congress is intent on reforming the financial industry in ways not attempted since the 1993 Glass-Steagall Act. This time around, hedge funds aren’t on the sidelines watching – they are in the bulls eye of the regulatory storm. The hedge fund industry faces headwinds it hasn’t sailed through in many years. Market conditions are lousy for some strategies but that’s not new – it happens every so often and funds adjust. What is new, what hasn’t often happened, is that Congress and the regulators believe hedge funds no longer merit exemption from most of the regulation that surrounds other financial players.

The new regulations will change the hedge fund landscape. Some are clearly mandated; others leave more discretion to the SEC, CFTC and the Federal Reserve. One thing that is clear is that banks and bank holding companies largely will be out of the hedge fund business. Subject to de minimis rules (no more than a 3% long-term ownership of any fund and no more than 3% of a bank’s Tier 1 capital in all funds), a banking entity will not be able to invest in or hold an investment in a hedge fund, nor will it be able to sponsor, bailout or lend its name to a fund. Banks still will be able to organise and offer hedge funds solely in the role of asset manager to a client, but there will be no new funds or investments in funds and disposals will be needed to get in line with the de minimis limits.

Will the prohibitions result in less overall money going into hedge funds? I doubt it. I predict that after a short period of adjustment, the flow of money to hedge funds will be driven, as the flow of money usually is driven, by investment results of hedge funds.

But performance may be harder to achieve. Changes in derivatives regulation will create complications. Big hedge funds are likely to be treated as “major swap participants.” That means they will be subject to new margin requirements. Leverage will not be set solely in the market because Congress has seen enough of what it considers to be market failures to safely constrain leverage. With respect to derivatives, leverage will be limited to the lower of what the market will provide and what the regulators will allow. Big hedge funds also may be subjected to capital requirements that raise the cost of doing business or limit a fund’s ability to implement particular strategies. On top of that, regulators can impose position limits. It will be more difficult to produce pre-regulation returns after funds are constrained by margin, capital and position limit rules.

To make fund managers’ lives even more interesting, regulators will have a lot of discretion regarding the margin, capital, and position rules. Regulators are expected to change those rules whenever changes are advisable in order to ensure the safety and soundness of a hedge fund or to protect the financial system. This means that a sponsor could launch a fund with managers who have a strong record, using strategies that later are made less profitable or even unfeasible because of changes in the rules. More of the derivatives traded by hedge funds will be cleared through clearing houses or swap execution facilities. More information about trades and prices will be available, often in real time. This may lead to lower profits for funds working strategies that can be easily copied but may also provide opportunities for strategies that can use the information. In general, more public information makes it more difficult to maintain arbitrage profits.

Hedge funds that are big enough in some way to be deemed “major swap participants” alsowill have to comply with a new set of business conduct standards. For example, if a major swap participant hedge fund deals with counterparties who are not major swap participants or swap dealers, the fund will have to disclose material risks and characteristics of swaps, pricing information, and any conflicts of interest or material incentives the fund may have.

Major swap participant funds will have to supervise their business diligently, whatever that means – and it might mean whatever a jury composed of people who have no idea what a hedge fund is decides it means. The provisions remind me of the pages of material risk disclosure lawyers write into private placement memoranda and public offering statements. They also remind me that there are lawyers waiting to pounce on a fund whenever they can find a client who lost money. The word processors in those firms now will contain boilerplate allegations regarding material disclosure, fair and balanced, and good faith and fair dealing.

The risk goes up when a major swap participant hedge fund deals with “special entities”: certain government entities, endowment funds, and pension and retirement plans. Hedge funds will need to have a reasonable belief that the entity they are dealing with is advised by an independent representative who, inter alia, is able to evaluate the transaction and its risks and who provides written representations to the entity regarding fair pricing. This is a big obligation. As we once again recently learned, the best minds in the industry can’t always evaluate all the risks that lurk in complicated vehicles or in corners of apparently far-removed markets.

This will create an industry of advisers and a nightmare for hedge funds. The independent representative will be hired by someone at the entity and will influence the entity’s decision concerning whether to do a transaction. What if the hedge fund isn’t sure the representative is able to evaluate the transaction and its risks? To whom do you bring this up? The representative isn’t going to love you if you mention it to the entity paying its fee. The person at the entity who picked the representative isn’t going to love you if you tell her she chose a representative who might not be up to the task. Of course, if a transaction later goes against the entity, she might be quick to accuse the fund of not fulfilling its obligation to have a reasonable basis for believing the representative to be capable. It could be a good bargaining lever to force a fund into a settlement.

These are big changes, but they might not be the biggest change. In the past, the hedge fund industry avoided most of the regulatory web surrounding the financial industry. The main rationale for most of the prior regulation was to reduce the chance of severe losses falling on people who could least avoid or afford them. Those people rarely invested in hedge funds, so hedge funds enjoyed life outside the scope of most regulation. But the success of hedge funds means that money has flowed in from pension funds and municipalities, meaning the failure of a mega fund can threaten the highly-interconnected financial system, hurting everyone.

Washington no longer believes the old rationales for exempting hedge funds from the regulatory web. Neither does London, Berlin or Brussels. The long-term consequences remain to be seen. They are likely to go beyond the restrictions, burdens and costs hedge funds face from the current legislation. The industry is entering a new era like the brokerage industry did 35 years ago. It survived by adapting. Now it’s the hedge fund industry’s time to change.

Erik Gordon is Assistant Clinical Professor and Associate Director of the Zell Lurie Institute, Center for Venture Capital and Private Equity Finance, Ross School of Business at the University of Michigan.