Hedge funds act to stay out of regulatory spotlight

The impact of the credit crunch on leading investment banks has taken the regulatory heat off hedge funds for the time being - and the Hedge Fund Standards Board intends to keep it that way.
By None

The impact of the credit crunch on leading investment banks has taken the regulatory heat off hedge funds for the time being – and the Hedge Fund Standards Board intends to keep it that way.

Few could begrudge any hedge funds that have enjoyed a little schadenfreude recently. The quarterly announcements by investment banks of still further losses from their investments in the US sub-prime mortgage market have diverted the media and regulatory spotlight away from hedge funds, allowing them to trade in the shade they are known to prefer. Well, not quite. Next month, many hedge funds will come out into the light by announcing their commitment to an initiative that addresses widespread concerns over the sector’s transparency and risk management.

The initiative – a set of industry-wide standards monitored by the Hedge Fund Standards Board – had its genesis in the G8 summit in spring 2007, which revealed considerable concern by the governments of leading industrialised economies over the opacity of hedge funds and their potential for causing financial instability. Having been blamed for more than their fair share of crises and scandals, the threat of large-scale regulatory intervention was the final straw for 14 large hedge funds, including GLG Partners, CQS and Marshall Wace.

Under the chairmanship of Sir Andrew Large, a former deputy governor of the Bank of England and head of the Securities and Investments Board (a fore-runner to the UK’s Financial Services Authority), the funds focused on delineating best practice in four areas that seemed of particular concern: opacity; activism; risk management; and valuation. The resultant standards were sent out for consultation in October 2007 and the final report of the Hedge Fund Working Group was published in January 2008.

Since then, the Hedge Funds Standards Board has been established under Antonio Borges, a former Goldman Sachs vice-chairman and dean of French business school INSEAD, to administer the standards and manage the process by which hedge funds participate. Thomas Deinet, a senior consultant to the HFSB, says signatories have been “rolling in” and the total number of hedge funds committed to the standards will be announced in September, prior to the first HFSB conference on October 15.

A key feature of the HFSB regime is its ‘comply or explain’ approach to ensuring that hedge funds observe its standards, which allows hedge funds to maintain practices that deviate from the standards if they explain to investors how their processes support HFSB principles. “The hedge fund industry is very diverse, in terms of size, strategy and nature of firm,” says Deinet. “‘Comply or explain’ avoids forcing a one-size-fits-all approach and so caters for the specific characteristics of funds and accommodates dynamism. ‘Comply or explain’ ultimately rests on disclosure, and thereby avoids a very detailed level of prescription.” The HFSB will also use these explanations to help determine where current standards need updating. “The information provided by hedge funds will shed light on how best practice has evolved,” says Deinet.

So far, reaction has been overwhelmingly positive, says Deinet. A recent KPMG survey of pension investors revealed that 80% of investors would favour hedge funds that conform to the HFSB’s standards. Political and regulatory pressures have also diminished. Europe’s political leaders welcomed the voluntary best practice standards of the HFSB in a joint communiqué in January and the Bank for International Settlements’ Financial Stability Forum has also recognised the standards and the willingness of hedge fund managers to play their part in strengthening financial markets.

Although Deinet insists that hedge fund managers typically have more effective control of risk than investment banks, because “the interests of investors and managers are much better aligned”, he admits that much work remains to be done before hedge funds lose their perceived veil of secrecy.

“We also recognise that there are broader misconceptions about the industry, and we are seeking to address these by providing additional information in the near future,” he says.