Vol 5 (2008) - Issue 3

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Can Flower Power Protect Hedge Funds: Regulatory Developments for UK Hedge Fund Managers

Most funds renew the flowers in reception with such frequency that one foreign based regulator is said to know something is wrong if he sees that the floral decoration is no longer fresh. In this article I set out particular reasons why hedge fund managers (‘HFMs’) should be concerned about regulatory action and what, short of ensuring a fresh flower supply, HFMs can do to protect their positions

The FSA’s focus on HFMs

Amaranth; Long-Term Capital Management; Beacon Hill – these names form just part of the grim roll-call of hedge funds that have gone spectacularly wrong. The unpredictability of hedge funds –and the consequences of a heavily leveraged fund failing – have meant that the regulators such as the FSA are among those straining to detect shortcomings by HFMs.

In the general pool of funds, few can beat the market year-on-year. Over the last 10 years only about 27% of funds generally have been able to return more than the compound cost of borrowing the money for the investment at 5%.

Hedge funds are, in some ways, more likely to cause disappointment for an investor than the general pool of funds. Not all funds truly ‘hedge’ and most are fairly heavily leveraged (currently at around 2.4 times). To compound matters the fee structure of the funds (usually a ‘2% and 20%’) arguably encourages a risk taking approach. In terms of cost, fund of funds introduce a further layer of fees.

The population of hedge funds is marked by high mortality rates: the half life of a fund is probably five years. ‘Picking pennies up in front of a steamroller’ is the almost clichéd description of what an investor in an hedge fund is doing.

In October 2007 the FSA issued Market Watch, a newsletter on market conduct and transaction reporting issues. The FSA had undertaken a programme of visits to a cross section of HFMs to review the controls that they had in place to mitigate the risk of market abuse. The FSA said that they were ‘disappointed by some of what we saw. We will be following up with the firms visited and are also launching a programme of visits to a wider cross section’ of HFMs.

The FSA has been subject to strident criticism in the UK press for its handling of Northern Rock. In circumstances such as these one would expect HFMs – a potential risk area – to come under particular scrutiny. In the remainder of this article I set out what, in my view, HFMs can do to allay concerns of the FSA.

Compliance culture

Jack G Gaine, President of the US Managed Funds Association said in an interview (in the context of bailouts) that the ‘one characteristic of hedge funds that separates them from others … would be the entrepreneurial nature and the single manager by and large’.

This entrepreneurial nature has often been fostered on the trading floor (or at least is unlikely to have been nurtured in the compliance department). There are obvious benefits to such a buccaneering spirit but it has traditionally been felt that the flip side of such characteristics has been to not place a great deal of emphasis on compliance issues.

Whatever the reason for it, the FSA commented in their recent newsletter that they were ‘particularly disappointed at the level and standard of training’ at some of the HFMs visited. ‘While there are pockets of highquality training, we found that sometimes the level of training was non-existent, low and/or of poor quality. Senior management must recognize their responsibilities to ensure that their staff are adequately trained’.

Some HFMs reported to the FSA that their size did not warrant a full-time compliance officer but say it is difficult to obtain adequate compliance support. Some questioned the quality of some of the consultants available. The FSA has recognized that there is some validity in these concerns but think that advisers with relevant sector experience are available.