Charles Gradante of Hennessee Group talks to Edmund Grouse and gives his views on why hedge fund managers should not be unduly worried about the prospect of regulation in the US.
Directly monitoring hedge fund managers can be costly to implement and lacking in effectiveness as was proven last year. Charles Gradante, Managing Principal and Co-Founder of The Hennessee Group, believes that the answer lies in indirect monitoring of the hedge fund industry through information gathering from the industry 'gatekeepers' (the term used to refer to the industry's essential service providers). Gradante states that this approach would bring about the transparency longed for by regulators while leaving managers with the nimbleness they require to do their job properly.
The idea has been proposed before. "I first said it before the Senate in 1999 in relation to LTCM and I've been saying it since. Now it seems the news releases we're seeing show that they're beginning to get the idea," says Gradante. Indeed in a speech at the Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference, Ben Bernanke, the Chairman of the Federal Reserve stated, "Continued focus on counterparty risk management is likely the best course for addressing systemic concerns related to hedge funds." Clearly seven years of nagging is beginning to pay off.
The system focuses on these so-called gatekeepers (prime brokers, fund administrators, investment banks and commercial banks) and has three main aims:
Under the Hennessee Group's proposal, systemic risk, one of the issues keeping regulators awake at night, could be monitored and mitigated by gatekeepers. "The top 100hedge funds in the US hold over 50% of the assets and these are the only ones big enough to generate systemic risk," says Gradante, "So you only need to monitor those guys." According to research carried out by Gradante's Hennessee Group, 90% of US hedge funds use one of ten prime brokers. Therefore the vast majority of information sought by regulators already resides with prime brokers, who are fully regulated by the SEC. Gradante believes that data on hedge fund positions could be delivered to the Federal Reserve and the SEC by the prime brokers. Data could include the amount of leverage, concentration of positions and information on use of complex, potentially illiquid instruments such as structured derivatives. In this way the regulatory authorities could build up an image of hedge fund positions and gain that longed for insight into the industry.
But will managers be happy to have information concerning their holdings sent to regulators? Manager fears regarding transparency of positions are ill-founded according to Gradante. "Hedge funds currently use several prime brokers for a single trade. They put each leg of a trade with a different broker so that they keep the brokers guessing and do not reveal their positions. Therefore there would be no increase in the transparency of their positions." Another option could be for prime brokers to report aggregate information on the industry and thus avoid revealing any data on individual hedge funds. If the authorities decided that the figures were straying too far from acceptable levels then they could drill down to find more specific information. A final possibility is that hedge funds, or at least the 100 largest, could be given the equivalent of CUSIP numbers (a number identifying most securities, including stocks of all registered US and Canadian companies, and US government and municipal bonds) to track their activity through prime brokers, who in turn would report data to the SEC, the Treasury, and the Federal Reserve. This would allow significant transparency into the use of leverage and potential systemic risk.
Gradante believes that focusing on gatekeepers could also be the best way to protect investors from fraud and simultaneously establish best practices for accounting within the industry. He proposes two changes to the process of valuing hedge fund assets. "We at the Hennessee Group feel net asset value (NAV) should be computed by an institution other than the firm's accountants on a monthly or at least quarterly basis." Currently in the US an annual audit is carried out but hedge funds do not need to compute and supply a monthly or quarterly figure for NAV. "The lower frequency of asset valuation increases the risk of fraud especially for those below the $1 billion mark which are more manoeuvrable," says Gradante. "In the UK, managers have to provide monthly figures and there is a far lower instance of fraud in the hedge fund community." Secondly, Gradante thinks an additional safeguard could be implemented to protect investors against fraud.
He believes that accountancy firms could send K-1 forms directly to the limited partners rather than via the fund managers. A few accountancy firms do this already but it needs to become an established part of industry best practices. The current practice of sending the forms to the hedge fund managers who then forward them to limited partners creates the opportunity for fraud as it is very easy to modify figures in documents. There have been several instances of fraud where hedge fund managers have modified their figures. By increasing checks to a monthly or quarterly frequency and sending reports direct to the limited partners Gradante believes opportunities for fraud will be drastically reduced. According to Gradante, support for the change should be widespread as the additional cost involved in the increased number of NAVs would be minimal and hedge funds would gainfrom the security and credibility that go with a monthly evaluation.
Says Gradante: "Hedge funds are viewed as an effective portfolio diversifier. The Senate wishes to give the same opportunity of diversifying investments to less wealthy people and so the hedge fund regulation question came about." Rather than open hedge funds up to the retail market he proposes broadening the mandate of mutual funds that are licensed to act like hedge funds. Those mutual funds are allowed to short stocks and use derivatives but only in a small proportion of their portfolio. By raising the quotas, the SEC would give investors who do not qualify for accredited status the ability to diversify their portfolios. Couple that with the fact that the SEC recently raised the minimum level for accredited investor status to $2.5 million in assets and it would mean that stringent regulation would not be needed for hedge funds as retail investors would be blocked from using the opaque and complex investment vehicles while still getting access to the diversifying qualities of hedge fund strategies. Gradante adds, "Money spent on regulation is not to protect high-net-worth individuals and institutions which have their own lawyers and advisors. Instead it should be used for the average investor who may not be able to afford informed advisors."
By gathering information from the service providers who act as gatekeepers to the industry, regulatory authorities and government agencies can gain transparency into the $1.442 trillion hedge fund industry and monitor systemic risk. Furthermore if the SEC broadened the mandate for certain mutual funds to use hedge fund strategies then those who did not qualify for access to hedge funds could still access the benefits of hedge fund strategies. For a regulatory authority which is often accused of being heavy-handed this indirect solution may be the way forward.