Hedge funds have been widely embraced by investors, from high-net worth individuals to the institutions, looking to create greater returns than those offered bymore traditional investments. With the large expansion of the market, and the risks involved in these collective investment vehicles widely discussed, one would expect investors to be fully aware of the potential pitfalls associated with these investments. However, many investors are still taking a naive approach to hedge funds. Although they accept that the value of their investment may go up or down, depending on market conditions and the success or otherwise of the fund manager’s investment strategy, many investors do not appreciate the other risks associated with investing in hedge funds such as conflicts of interest, side letters and lock-ins. In June 2007, as part of what was described as ‘an exercise in industry-led market discipline’, the Hedge Fund Working Group, made up of 14 fund managers (but surprisingly no investor representatives) under the chairmanship of Sir Andrew Large, began deliberations on producing best practice standards and guidance to meet these and other concerns. The group published a consultation paper in October 2007 and a final report on 22 January 2008, which sets out best practice standards and guidance for fund managers, in respect of their management activities. A new Hedge Fund Standards Board and Board of Trustees will act as guardians of the standards.

Potential pitfalls

Before considering how effective the new regime is likely to be, it is worth identifying some of the main pitfalls faced by the unwary investor. These problems occur around three key areas:

• Disclosure – For many investors a lack of transparency is problematic, with fund documentation often failing to provide adequate disclosure on key issues such as valuation methodology, investment strategy, redemption rights, penalties and the manager’s remuneration. One example lies with the use by managers of side letters which confer preferential treatment on certain investors at the expense of others, for example, in relation to lower fees and enhanced liquidity.
• Conflicts of interest – The complex web of relationships which exist around hedge funds gives rise to significant potential conflicts of interest, in particular the mechanism for valuing funds and the link between fund value and the manager’s remuneration. Portfolios which contain highly illiquid assets means valuations are complex and potentially open to abuse. The use of ‘side pockets’ has attracted attention for their role in enabling managers to conceal poorly performing investments.
• Fund governance – There may be no adequate governance arrangements in place to deal properly with a fund’s risk management activities, including portfolio and operational risks and conflicts of interest. In particular, given the leveraged nature of many hedge funds their cash positions are more sensitive to sudden market movements and poor liquidity risk management may result in the fund being unable to meet its obligations, including investor redemptions.

The new regime

The new standards put forward by the HFWG are based on the FSA’s principles of good business conduct and represent a voluntary code without regulatory force. They attempt to draw a baseline of best practice in order to strengthen the confidence of investors, lenders, regulators and other market participants. Examples include:

• Disclosure – there should be an appropriate level of disclosure and explanation in the offering documents of the fund’s investment policy, strategy and risks. Side letters which contain material terms should be disclosed (Standards 1-4).
• Conflicts of interest – arrangements should be put in place aimed at addressing and mitigating conflicts of interest including in relation to asset valuation. Procedures should be adopted which aim to ensure a consistent approach to determining fair value. If side pockets are used then steps should be taken to describe the assets eligible for side pockets and disclosure made of other relevant issues such as when side pocketing is to occur and the calculation of management fees and performance fees (Standards 5,7).
• Fund governance – A liquidity management framework should be put in place to ensure that the liquidity profile of the fund’s investments aligns with the fund’s obligations (Standard 12). In addition, the manager must be proactive in seeking to ensure that a fund governance structure which is suitable and robust to oversee and handle potential conflicts of interest is put in place at the outset (Standard 21).

The adoption of a high level, non-prescriptive approach was seen by the HFWG to suit better the diverse, dynamic nature of the industry. Conformity with the standards will be through a ‘comply or explain’ regime. Managers will ‘comply’ if they become a signatory to the standards and either comply with each standard or explain that they will not and why.

The fact that the standards have no formal regulatory status (they do not have FSA confirmed guidance status) and are only to be monitored by the Standards Board (rather than enforced) does raise the inevitable question: what is the incentive for managers to comply? Here the HFWG puts its faith in market forces which it believes will encourage conformity and compliance through peer pressure and market pressure from investors.

How effective will the new regime be?

There is no doubt that many of the practices set out in the standards will be welcomed by investors. However, as the report recognises, it is only the beginning of the process and the effectiveness of the ‘comply or explain’ regime will rest on proper disclosure by the fund managers. There can be no guarantee that those that say they will conform to the standards will in fact do so. Whether market pressure is a sufficient incentive remains to be seen although with the presence of the institutional investors increasing this is likely to become more significant. If the initiative is to succeed the standards will also have to keep up with the fast changing demands of the market place. The key role of monitoring and updating the standards falls to the Standards Board and Trustees.

The extent to which hedge fund managers in other countries will sign up to the standards is presently unclear. In the USA, the US President’s Working Party on hedge funds is engaged in a parallel exercise. There will clearly be a need to consider the global convergence of standards over time and this will be part of the Trustees’ mandate. In the meantime, the view of the HFWG is that, because the standards attempt to mirror FSA principles, compliance with the standards will be seen as indicative of good practice in other countries. As such, there will be pressure to comply, not least because managers should be able to reduce their exposure to potential claims if they are seen to do so. Where responsibility for fund governance lies with the fund’s governing body rather than with the manager, the HFWG recommends funds should not focus unduly on legal relationships underlying fund governance. There needs to be confidence in the relationship between the manager and the governing body.

There is no doubt that the work of the HFWG and the promulgation of the best practice standards is an important step to securing greater investor protection in an industry which is still widely regarded as being highly secretive. However, whether or not market pressure will be sufficient on its own to ensure the success of the ‘comply or explain’ regime, only time will tell. What is not in doubt is that for any potential investor thinking of investing in hedge funds there remains no substitute for proper due diligence.

Jeremy Sharman is Head of Contentious Finance Group, at international law firm Bird & Bird