Hedge-Fund Managers Beware

March 25, 2003 Published Work
Connecticut Financial Tribune, March 24, 2003

Anticipating change and building integrity

Hedge funds have been making headlines in major newspapers lately, and it is not all good news. Nor is it the first time in recent memory that the media has flocked to stories of hedge fund fraud, huge losses, lagging investor confidence, and possible increases in regulation or disclosure. The attention is, at a minimum, a wake up call to hedge-fund managers. Managers need to take notice, identify concerns of regulators and investors alike, and prepare for what may be coming.

Hedge funds are lightly regulated investment pools with high minimum investment requirements that generally attract wealthy individuals and institutions, and adopt aggressive strategies not available to mutual funds.

Last May, outgoing Chairman Harvey Pitt announced the Securities Exchange Commission's formal fact-finding investigation of fraud, particularly among hedge funds. Alarmed by the "seismic boom in both number and total assets" of hedge funds, Pitt voiced his concerns about "whether the present state of regulation - or perhaps more accurately lack thereof - is in the public interest." That investigation concluded last month.

Events since May have done little to calm the SEC. During 2002, the SEC brought twelve enforcement actions against hedge-fund managers, as compared with just five in 2001 and four in 2000. A fifth of hedge funds around the world closed in 2002, and in early 2003, a prominent hedge fund, Gotham Partners, shut down its largest funds. (New York Attorney General Eliot Spitzer is currently investigating Gotham for alleged manipulation of stock prices.)

Such investigations and losses negatively impact investor confidence. Hedge-fund managers should worry about the possible consequences of such loss of faith by investors and also by those that advise them. The National Association of Security Dealers recently reminded its members of obligations to determine whether hedge funds are suitable investments for clients. Worried that its members sell hedge funds without disclosing risks about investment strategies or illiquidity, NASD noted that investment sophistication cannot be measured solely by a client's wealth.

All the attention does not necessarily mean that regulators will soon crack down on hedge funds. Some believe that just as talks in Congress triggered in 1998 by the collapse of Long-Term Capital Management never led to change, the SEC is too understaffed to initiate new policies, but others take the contrary view.

Possible Changes

In this post-Enron environment, the later view - that change is coming - seems apt. The public is skeptical and that skepticism, whether warranted or not, will have consequences. A survey conducted in November by InvestorForce of 100 corporate and public pension plans, foundations, and endowments found that 59 percent favored increased regulation of hedge funds.

January closed with the SEC's wrap up of its eight month investigation and proposals for change. The key proposals include requiring hedge-fund managers to register as investment advisers, increasing restrictions on who can invest, and targeting how funds market themselves.

Managers may see requirements for greater disclosures and face complicated questions about how much information is enough and how much is too much. A recent survey released by the International Association of Financial Engineers, an industry trade group, and Capital Market Risk Advisors, Inc., an investment advisor specializing in hedge funds, has already observed a disconnect between disclosures some investors want and those some hedge fund managers are willing to make.

Changes will most likely be targeted at the hot issues, including fraud among hedge-fund managers, conflicts associated with managing hedge funds alongside mutual funds, and direct and indirect marketing to retail investors. For example, managers might be directed to make enhanced disclosures about assets and valuation methodologies, and about performance. Funds might also have to register as investment companies and investment advisers, which would subject them to increased audits and documentation requirements. At best, managers could hope for less intrusive developments, such as requirements aimed at educating investors about risks uniquely associated with hedge funds, rather than regulations changing the nature of those risks.

What should hedge-fund managers do now as they hide from negative press attention and wait to see what will happen next? The best answer: don't just beware, be aware.

The buzz word to describe challenges facing corporate America today is integrity. President Bush used it in his recent State of the Union address, as did outgoing Chairman Harvey Pitt of the Securities Exchange Commission in his remarks last May when he announced the SEC's investigation on hedge-fund fraud.

Hedge-fund managers should counter each negative report with efforts to regain trust. That process entails not just abstaining from fraudulent practices, but also taking affirmative steps to determine just what investment strategies fall within legal boundaries.

Understanding what the securities laws do and do not allow is a substantial undertaking, and one that managers are not well-equipped to do on their own. With legal guidance, however, managers can look to current investigations of hedge funds and actions filed against hedge-fund managers and discover unmatched insight into what regulators and courts disfavor.

The benefits of all efforts to comply with the laws - either by developing compliance policies or by paying attention to enforcement efforts - far outweigh the costs. Those efforts may keep managers out of trouble now, make future compliance with new regulations easier, and build much-needed confidence in hedge-fund integrity.