1 May 2006
With the prospect of hedge fund listings arriving on our shores, regulators want less potential for conflicts and wider access for mainstream retail investors. By Jonathan Herbst"
Hedge funds have become increasingly important in global financial markets in recent years. In its report 'Financial Risk Outlook 2006', the Financial Services Authority (FSA) noted that London is the leading centre of hedge fund expertise in Europe and estimated the amount managed by local fund managers at more than £120bn. The FSA also estimates that there are more than 300 specialist hedge fund managers and more than 100 mainstream asset managers managing funds using hedge fund-style techniques.
As another sign that hedge funds are moving into the mainstream, the FSA recently proposed changes to the Listing Rules that would allow hedge funds to list in the UK for the first time. At the same time, there have been calls to allow wider access to hedge funds for retail investors than the regulatory regime currently allows.
The regulatory concerns
A number of commentators have expressed concern that some hedge fund managers may be pushing the limits of acceptable market practice in relation to, say, trading based on non-public information, and that compliance procedures within hedge fund managers are weak.
Their concerns will not have been allayed by the news that, earlier this year, the FSA fined hedge fund manager GLG Partners and its former trader Philippe Jabre £750,000 each for alleged market abuse. Jabre is appealing against the FSA's findings to the Financial Services and Markets Tribunal, while GLG had previously denied any wrongdoing.
In the US, the Securities and Exchange Commission (SEC) is also paying more attention to hedge funds. Rules came into force on 1 February this year which provide that a hedge fund manager with more than 14 US clients must register with the SEC, unless certain limited exemptions apply.
FSA proposals for change
In 2005, the FSA published two discussion papers:
• The 'DP05/3: Wider-range retail investment products: consumer protection in a rapidly changing world' paper looked at the increasing variety of investment products reaching the retail market and the extent to which private investors should be able to enjoy the potential benefits from investing in hedge funds, while maintaining adequate regulatory protection;
• The 'DP05/4: Hedge funds: a discussion of risk and regulatory engagement' paper looked at the market risks associated with hedge funds.
In March this year, the FSA issued feedback statements on both of these discussion papers. It plans a number of steps both to broaden access to hedge funds for retail investors and to strengthen regulatory protections. These measures will include reinforcing existing consumer information and awareness work and looking at the question of product-provider responsibility. The FSA also plans to consult early in 2007 on allowing funds of hedge funds to be sold to retail consumers in the UK.
As regards the regulation of hedge fund managers, the FSA is particularly concerned about asset valuations and the use of side letters.
In relation to asset valuations, concerns have been raised that the commonly used remuneration structure may lead to conflicts of interest. Remunerating the manager through performance fees may encourage the manager to overstate valuations, giving the appearance of higher performance and thus increasing fees.
Another concern is that administrators may find it harder to challenge valuations provided by managers due to increased hedge fund activity in assets that are mostly large, illiquid and thus difficult to price. The FSA proposes a programme of themed visits to a number of firms and expects to publish its findings later this year.
In relation to side letters, the FSA is worried that some larger investors receive more information and preferential redemption terms under the terms of side letters compared with other investors in the same share class, who may be unaware of the existence of the side letter and therefore be denied the same terms. Again, this raises the issue of a conflict of interest and the need for transparency surrounding such arrangements. The FSA suggests that such arrangements may well be a breach of its current principles, and in some circumstances could constitute a criminal offence if the side letter is found to have been dishonestly concealed.
Looking to the future
There is no doubt that the growth of hedge funds and their increasing influence on financial markets has caused many financial regulators to look closely at the risks associated with the way hedge funds operate. Yet there are also pressures to allow mainstream retail investors to enjoy some of the riches they have hitherto been denied from investing in hedge funds. Successfully balancing these two demands is the trick for regulators to pull off. At the same time, hedge fund managers are likely to find that the price they pay for the success of hedge funds is a tighter regulatory regime.
Jonathan Herbst is a partner at Norton Rose