The regulatory and economic grounds are shifting on hedge funds.  Those that are not toppling are being toppled by regulators or are beginning to plan for adjustments.  With the Brave New Regulatory World as yet unclear, what is clear is that both regulators and investors have less stomach for excessive fees and lockup periods and the abuse that they, sadly, sometimes inspire.  Each of the U.S., U.K. and Canada is now taking a deep look at how (no longer whether) to reform their hedge fund environment.

First, for those who may have heard the term but are unfamiliar with the concept, we look at a background on hedge funds. These are generally private investment funds that have a small number of sophisticated investors with each investor providing a large amount of money.  Hedge funds adopt different trading strategy, but have one thing in common: they rely heavily on the expertise of their portfolio managers to generate these returns and as such tend to have fee structures that benefit these managers. Until recently, this has usually been a 2% management fee and a 20% fee on profits generated by the fund.

To date, hedge funds are, in the minds of many, insufficiently regulated and not required to disclose what they should. Like many an unregulated area, this industry has become prone to some level of abuse, though most of its members are guilt-free and simply tarred with that brush.  Fee structures are one of the primary motivators of abuse.  They motivate funds to maximize AUM, or assets under management, a mere slippery slope away from artificially inflating assets.  This has led to two sorts of behavior from funds. Some have have actively cut their fees, partly to reassure investors and partly to support them during tough times. Others, sadly, have slipped and inflated assets, to their investors’ detriment…and, with an activist Securities and Exchange Commission (SEC) on the march, to their own.

Several major funds have announced fee reductions in recent weeks. Among those making this announcement: Centaurus Capital, a London-Based hedge fund firm and Perry Capital, of the U.S.  Centaurus has reportedly started a new fund with a 1.5% management fee and 15% fee on profits.  At the same time, they’re allowing their investors easier exit terms.  As opposed to quarterly withdrawals common in the industry, they are allowing monthly withdrawals with a 30 day notice, in an effort to be seen as more palatable by investors. At the same time, Perry Capital has offered its investors a 50% cut in the performance fees charged on its flagship $8 Billion fund.

By contrast, the abusive few, now exposed by regulators, seem to have been hard at work pumping up their assets.  Among them: Arthur Nadel, against whom the SEC brought civil action in federal court in Florida.  The SEC alleges that he overstated the value of the funds by approximately $300 million when in reality appears the funds have a total of less than $1 million in assets. In February, the SEC filed emergency civil action in Minnesota federal court against Paramount Partners LP alleging that it had sent out account statements in January 2009 claiming $17 million in investments when it only had $5.3 million in assets. Also in February the SEC brought action against Westgate Capital Management LLC in federal court in Manhattan claiming the hedge funds were marketed with false sales brochures showing near impossible investment returns. The managing member of the firm also named in the charges, James M. Nicholson, was barred from the brokerage industry in 2001 for supplying false information.

Along the same lines, Canadian enforcement has stepped up, with an enforcement action brought against Sextant Capital Management, a hedge fund group run by Otto Spork. The Ontario Securities Commission (OSC) initiated the action on December 8, 2008, alleging self-dealing and inflated valuations within its funds. It has since sought to appoint a receiver for all of the property and assets of the Sextant entities through the Ontario Superior Court of Justice.  In the spirit of selling coal to Newcastle, part of the self-dealing revolves around two Luxembourg companies, Iceland Glacier Products and Iceland Global Water 2 Partners SCA. Both companies reportedly own rights to glaciers in Iceland and intend to use those for developing and selling bottled water. A recent order in the proceeding has continued the enforcement action and temporary order until June 17.

This tug of war between self-regulation and self-dealing is happening against a backdrop of impending regulation, among many major economies. Consider efforts underway in the U.S., the U.K. and Canada (more properly Ontario, Canada’s major securities hub) and this becomes clear. The OSC, U.S. Congress, and the U.K.’s Financial Services Authority (FSA) have all shown renewed interest in hedge funds since the beginning of 2009. Interestingly, the SEC had previously attempted to require hedge fund registration but had the rule overturned in court which prompted the recent legislation introduced in Congress.

In the U.S., multiple efforts are underway.  Recently, the Hedge Fund Transparency Act was introduced by Senators Grassley and Levin on January 29. The bill seeks to give the SEC regulatory power under the Investment Company Act of 1940 to require all funds (hedge funds, venture funds, and private equity funds) with $50 million or greater in assets to register and file annual disclosure statements. These requirements would apply to U.S. and non-U.S. funds soliciting investors within the U.S. and is meant to address a decision by the D.C. Circuit Court of Appeals in 2006 which overturned an earlier attempt by the SEC to require registration of hedge funds under the Investment Advisors Act.

Most recently, in the U.K., recent recommendations by the chairman of the FSA, Lord Adair Turner, on a regulatory overhaul of the United Kingdom’s financial industry include increased oversight of the hedge fund industry. In echoing sentiments by Federal Reserve Chairman Bernanke, Lord Turner points out the need to not so much focus on the structure of the entity but instead the overall impact the entity has on the financial system.

In Canada, the OSC launched a focused and detailed compliance review of hedge funds within Canada in February of this year. The probe was prompted, in part, by the Madoff Ponzi scheme revelations and the failures by the SEC to detect it. The OSC is not only looking at Canadian hedge funds potential exposure to Madoff, but has also sought broader information around the composition and valuation of the portfolios, the percentage of retail investors in the funds, and an eighteen month history of subscriptions and redemptions. The OSC has been tight-lipped about this investigation with most details coming from news reports or law firm memoranda.  For the moment, suffice it to say that this review is deeper than that performed in 2007 by the Canadian Securities Administrators (CSA), which itself reached some rather detailed recommendations.

As public outcry over economic downturns and investment scandals continues to rise, regulators are looking at those areas least understood, including hedge funds. Because of the complexity and relative opaqueness hedge funds seem to be a primary regulatory target. At the same time, as hedge funds have been battered by the market volatility, they may see increased regulation as means of receiving some sort of validation, potentially comforting skittish investors.

Published: March 19, 2009