Tuesday, March 24, 2009

Hedge Funds and Rabid Regulation

With Obama urging Congress to empower regulatory units and quicken regulation, one is encouraged to ponder on philosophically.

Are we simply overcompensating for having been under-regulated or poorly regulated? Are we ready to impose and adopt new regulation? Is regulation even a cure?

As one can imagine, poor regulation in its abundance may have a similarly negative effect to poor regulation in its absence. Perhaps there's a covenient middle ground. But the speedy (raging) imposition of new regulation simply cannot be the answer: it hinders growth and poses significant operational burden at a time when the U.S. -- no, world -- economy simply cannot support it. And it's expensive.

Now we don't contend that all regulation is bad. Some of it, for example the rating agency debate, is healthy. But when the political maneuvering becomes extreme it can undo much of the good work that came before it. Hedge funds, for example, are appealing due to the leverage and return they can achieve. But they become infeasible under certain regulatory and disclosure regimes. We are, in effect, ensuring that very few hedge funds can and would want to continue existing. The move towads being an asset manager, consulting firm, or bank would be much more appealing: if you're going to be heavily regulated anyway, why not take the upside?

The hedge fund industry certainly has a few items worthy of an additional eye (i.e., some form of supervision). We've spoken a little about sidepockets and challenges in consistently presenting fair value. Side letters, as an aside, and redemption gates are also obviously problematic and requiring attention.

And so too are fund documents: not only the restrictions they impose, but more importantly the capabilities and flexibilities their language allows. As Risk Without Reward (RWR) points out, the idea of "buyer beware" is only useful if the documents have not been drafted in such a way that allows just about anything "in the sole discretion of the investment manager."

For example, CDO indentures for managed deals have various sections describing what are acceptable Substitute Collateral Debt Securities. Fund documents, less so.(Even today we saw -- and it's not necessarily a bad thing -- two of Eaton Vance's funds approving investment in alternative new asset classes, with one fund allowing investments in commercial mortgage-backed securities (CMBS) and the short-selling of sovereign bonds subject to certain limits. For another way managers get around regulation see Regulatory Capital Arbitrage.)

Aside from investment criteria investors should look at operating expenses for the fund. Does the hedge fund pass legal and formation fees onto the fund owners? Okay. Are investors alone paying for data and vendor tools that are used for the manager's other (possibly prop capital) funds? Is that sharing pro-rata? And is the fund paying for the marketing of its shares? (Hat tip to RWR for this catch). Data and analytical tools are expensive, as can be the fund marketer's traveling expenses. Frustrating indeed. But time to ask those tough questions. While we still have hedge funds.


Comtesse du Barry said...

This creates work for Washington. In good times the regulation created doesn't support the bad times and so they adjust. The regulation created now will be superfluous in the good times and so they can readjust. Our regulation sways like a candle in the wind.

Anonymous said...

I totally agree that our “leaders” in Congress should slow down and think rather than moving too fast just to produce so called “aid.” The markets have been saying they don’t approve, Congress should listen.


Private equity is nothing more than a blood sucking way to drain the life and vitality out of a company in order to make a fast buck. Buy a company using lots of leverage. Along with some dirty little tricks like buying quietly a majority stake in a company behind everyones back without making a tender offer along with and including buying the shares at a big discount to what they are actually worth without declaring your intentions' to deceive investors. Than declare that your taking the company private and offer as little as possible for the remaining shares which are worth twice as much money as your offering for them and than say your saving the company what a bad bad joke. These private equity firms will do anything to come out ahead on the bottom line. Like sell all the real estate a company owns' sell or loan out patients and copyrights' tradmarks' pit one state against another threatening to move a division of their company to another state if they do not receive a subsidy or some generous tax breaks. Sell off divisions of the company that are undervalued. Fire as many workers as you possibly can' along with cutting the wages and benifits of the remaining employees to increase the bottom line. Squeeze price concessions from loyal vendors that are heavely dependent on a large part of their sales to your company. Tell your unions its take drastic cuts in wages and benifits or else risk having your plant shut down. And finally when you bring your company public again hire that so ethical investment banking firm goldman sachs to overhype the value of your public offering to increase the amount of money you will receive when the company becomes a public company again and at that point you bail out of the stock leaving a company torn into pieces from what it originally was.