Hedge funds have been accused of many things in recent months. A standard criticism is that the industry at least aggravated, and possibly even caused, the financial crisis by short-selling bank shares. To use tabloid parlance, hedge funds have been ‘cashing in on other people’s misery’.
Even politicians have been queuing up to put the boot in. In January John McFall MP, the chairman of the Treasury Committee, told a group of leading fund managers: “You’re snubbing the public; not only that, but you’re making shedloads of money.”
It is a hostile environment, even for investors used to their fair share of public criticism.
But behind the invective is an industry in a state of flux. Some 18 months ago, this column examined the legal implications of a new voluntary code of conduct set up by a group of leading hedge funds.
The guidelines, drafted with the help of Herbert Smith, were intended to show that fund managers were not the cash-hungry wolves they were being portrayed as.
The guidelines were also, as Simmons & Simmons financial services partner Darren Fox points out, designed to stave off the unwelcome attentions of regulators.
“The rationale for the code of standards was to pre-empt the need for regulators to step in,” Fox says. “They weren’t confident that regulators would get it right.”
More than a year – and several bank collapses – later, it is clear that the code has not had the desired effect.
At the select committee meeting in January, McFall criticised the low take-up of the standards within London’s hedge fund community.
“Out of 1,000 potential members, you’ve only got 34,” he said. “Of the 34, 14 were those who drew it up in the first place. If I were a recruitment manager with a record like that, I’d be sacked.”
Hardly a glowing endorsement of the Hedge Fund Standards Board, or the work of Herbert Smith, which was itself something of a surprise appointment as legal adviser on the guidelines.
In fairness, several large funds have since signed up, including the Children’s Investment Fund and BlackRock. And besides, the signatories make up more than half of the total assets managed by hedge funds in Europe.
The problem with the code is not lack of support, say hedge fund lawyers. It is that it is has been completely overshadowed by the looming spectre of EU regulation.
The European Commission’s draft directive on alternative investment fund managers has had investors rushing to their legal advisers.
“It would completely and radically alter the way hedge funds are set up and run,” comments Dechert partner Peter Astleford, who adds: “Some of the proposed directive is very sensible and would raise standards. Other parts really go too far.”
Fox is less complimentary. “The current draft is completely unworkable,” he says. “It would be disastrous for the industry.”
There are two parts of the directive that are causing funds lawyers to lose the most sleep: a requirement to have all assets held in custody by European banks, which would restrict investment outside of Europe, and a proposal that the regulatory authorities could set leverage limits.
“It’s hard to know whether the EU is going to exercise that in a way that’s sympathetic to investors,” says Astleford.
The big concern for London hedge fund specialists such as Simmons, Dechert and Schulte Roth & Zabel, is that their clients will simply decamp to New York, Singapore or the Cayman Islands.
This is amplified by the new 50 per cent tax rate, due to come into force in April next year, which will hit the pockets of millionaire hedge fund managers.
“When you get to the stage when somebody’s being taxed more than they make themselves, that gives rise to a reduction in business,” says Astleford.
There is some evidence that this is already happening. Research published by International Financial Services London in September found that London’s share of global hedge fund assets fell by 2 per cent in 2008, while New York’s increased by the same amount.
It will be difficult to tell the exact effect of both these factors until next year, especially as it is likely that the EU directive will change in the face of some frantic lobbying by the hedge fund industry.
“We’re quietly confident that the worst excesses of the directive are going to be rectified,” says Fox.
In the meantime, hedge funds are getting on with what they do best – making “shedloads of money”.
Astleford has noticed a change in atmosphere during the past three months. Whereas at the height of the financial crisis the vast majority of his time was taken up with distressed work for funds facing difficulties, that figure is now more like 20 per cent.
The rest is more regular work, such as setting up funds and making investments.
Despite the changing face of the industry, Astleford is optimistic. “Broadly, I think the picture is much brighter than it was,” he says.