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.