Don’t water down the rules

Delegates at GAIM Ops Cayman were told to embrace the wave of hedge fund regulation coming out of the US and Europe and to demonstrate the value of hedge funds.

Now in its sixth year, GAIM Ops Cayman is the largest event for hedge fund operational due diligence, compliance and risk management. After the theme of the 2010 conference was transparency within the industry, 2011 “is clearly the year of regulation”, noted Michael Tannenbaum, partner at law firm Tannenbaum Helpern Syracuse & Hirschtritt, a point that was reflected in most panel discussions and presentations.

Cayman regime to become easier

Ingrid Pierce, the head of Walkers’ fund practice in Cayman, agreed there certainly was a “regulation buzz” in the US with the Dodd Frank Act and in Europe with the Alternative Investment Fund Managers Directive.

However, locally “Cayman regulation itself has been pretty level for the past few years”, she said. “People have been rather pleased with the way the regulatory regime has reacted here.”

The next step will be how Cayman is going to respond to US and European legislation and regulation.

“Whatever is happening, the Cayman regime will be able to respond robustly and swiftly and to the extent that new regulations are going to be required I don’t think that they are going to be particularly burdensome to fund managers,” Pierce concluded, saying that in her view “the compliance with the Cayman regime is actually going to become quite a lot easier”.

With regard to European regulation she is, however, concerned about the extent to which US managers will be able to market into the EU and the differences between national regulatory systems.

“There is not a lot of harmony in this regulation, everybody is gearing up to being highly regulated, but you have to comply with four or five different regimes,” she said.

Edward Dougherty, a tax partner with Deloitte in New York, noted a perception that self regulation does not work. In fact, he added, “Congress asked us to take steps in our compliance programmes that many investors expected already.”

While Dougherty does not believe that regulation in itself is a good thing, he argued that effective regulation can be very powerful. What happens when regulation is watered down or weakened by lobbyists, he said, could be seen in the Massey Coal mine disaster or the Deepwater Horizon accident in the Gulf of Mexico. Even in the mortgage crisis there was no shortage of regulators, Dougherty said, but he noted that these were “virtually matched by corporate lobbyists”.

Highlighting that 13,000 lobbyists are registered in Washington with a budget of US$3.5 billion, he pointed out that 6.5 million of lobbying dollars are available per member of Congress.

When facing the Dodd Frank Act and other pieces of regulation, he therefore advised hedge fund professionals to understand what is required from new regulation, to be ready to implement the rules, to strive to achieve the spirit of the rules and to “be a champion for investor protection”.

“Don’t try to water down the rules to save a few dollars and get the government to look the other way,” he said, encouraging delegates to “support the efforts to make sure that the SEC and the CFTC are fully funded so that they can do their jobs”.

“If we have another Madoff the entire industry will suffer,” he warned.

The worth of hedge funds

He further reminded delegates that through pension funds the real investors in hedge funds are regular people, “all of whom are counting on their employers to make good on promises to protect their finances for retirement”.

In order for hedge funds to demonstrate their worth, Dougherty presented a 10-point list.

This list included the charitable nature of hedge funds, highlighted by the top 25 hedge fund charitable foundations alone managing $6.1 billion in 2010.

At the same time, he said, everybody in the industry is paying taxes. The top 25 managers earned in excess of $22 billion in 2010 and most of that income will be taxed at a higher rate than the long term capital gains tax, he said.

Dougherty also named the shareholder activism exercised by hedge funds, which ultimately unlocks value for all shareholders, as well as innovation and new ideas that are brought to the market by hedge funds.

In terms of employment, he quoted the Alternative Investment Managers Association’s estimate that 100,000 people are directly and 200,000 people indirectly employed by hedge funds.

Hedge funds enable investors to reach their goals through diversification and capital preservation in combination with appropriate risk management, he said.

Moreover, hedge funds allow investors access to investments globally.

Citing the example of James Chanos, who suspected problems at Enron long before everyone else, Dougherty noted that hedge fund managers are also at the forefront of ferreting out fraud.

Even during the financial crisis, hedge funds were a solution rather than the problem by becoming key liquidity providers and lenders during the recession, he argued.

However, the most important point, Dougherty said, is that hedge funds will have a key role to play in solving the pension problems of the US states.

Funds of funds model not dead

This point was picked up by Andrew Rabinowitz, COO and partner at Marathon Asset Management, in a debate about whether the funds of funds model will survive.

The market share of funds of funds has declined from 48 per cent to 40 per cent, in the face of criticism of double layered fees, Madoff exposure and not enough due diligence among others. Yet the fund of funds model is not dead, a panel at the conference agreed.

Rabinowitz said the unfunded pension liabilities in most US states mean that pension providers simply will have to allocate more investments to hedge funds. He named a range of advantages that pension funds may be looking for from funds of funds including aggregate risks, operational due diligence, aggregate information and reporting.

Rabinowitz anticipates a shift from high net worth investors in funds of funds to institutional investors in funds of funds.

John Ward, global head of operation due diligence with EIM, concurred that the model is not dead but argued that it is going to shift significantly.

Naming the pressure on fees and increasing demand in terms of due diligence and operational due diligence requests from investors, Ward noted that funds of funds are facing an increasing workload amidst a fee squeeze.

Even Terry Raby, operational risk manager with Universities Superannuation Scheme, which does not invest in funds of funds believes the model will persist.

He stated that either you want to become a fund of funds yourself or you get someone to do it for you.

While becoming a fund of funds yourself has the advantage that you can select the strategy that suits ones particular circumstances, it is all a matter of costs, staff, systems and risk-adjusted returns to determine which route the investor should follow.