Alternative Investment Directive

The rise and power of hedge funds represents one of the biggest changes to the global economy over the past half century.

Predominantly limited liability partnerships, most hedge funds are exempted from much of the regulation that applies to investment banks and mutual funds, and as pools of highly mobile capital they have fast developed the reputation of being able to move financial market mountains by anticipating future expectations. Hedge funds thrive on volatility so the crux of the controversy surrounding them is the degree to which they either cause or affect fundamental shifts in financial markets.

This unpoliced, unsupervised and until recent years low profile sector of the financial services world is now firmly in the sights of the European Commission. However, its proposed Directive to regulate hedge funds and the private equity sphere betrays a lack of understanding of the workings of the business. Critics of these proposals regard the onerous reporting and disclosure regime as predominantly politically motivated.

The origins of continental Europe’s targeting of hedge funds pre-date the credit crunch. Fully four years ago German economic ministers dubbed as ‘locusts’ those hedge funds which had precipitated upheaval at the Deutsche Boerse. To many in the Parisienne financial community, hedge funds represent the paradigm of the ‘Anglo-Saxon’ capitalist model. To its opponents, the European Commission’s attention in this area appears to have been promoted by an unholy alliance of continental bankers and politicians, most concerned to effect a power grab – 80% of hedge fund assets managed in Europe are accounted for out of London; fewer than one-twentieth originate from Paris.

For the plain truth is that the asset management business has not been directly implicated in the global financial crisis – so why does the EU give such priority to their regulation? Typically hedge funds are small set-up businesses – a far cry from the large, international banking institutions that jeopardised the entire global financial system last autumn. Their offshore domicility owes more to the need for simplicity in tax and regulation with places such as the Cayman Islands not being beset by double-tax treaties and reclaim bureaucracy.

The impetus for a European Directive derives from panic in response to the economic crisis alongside a partisan vision of hedge funds and private equity as a Wild West show of amoral speculators and asset-strippers. But there has been no crisis of asset management. Unlike banks, hedge funds neither leveraged themselves to the hilt (they lacked the balance sheet clout to do so even if they had wanted to) nor ran down from adequate levels of liquidity. Indeed those which have failed have not threatened the entire financial system.

In truth one of the unsung successes of the Financial Services Authority has been its ability to keep the hedge funds sector ticking along nicely in recent years. So it cannot make sense for a European Directive to insist upon onerous hedge fund registration requirements by giving Commission officials the right of veto over their investment strategies. This will simply result in the drying up of investment from outside the EU to hedge funds here which is against not only UK, but also French and German interests.

All that investors in this global market ask is that they are free to choose their investment managers. Instead this proposed brave new world for hedge funds and private equity will enforce EU-based investors to abide by a system of rules whereby they will have to instruct EU-based managers and place their assets in EU funds.

A more sensible approach would be to examine how and why private equity and hedge funds became so powerful so rapidly. The homogenising of mainstream institutions in the financial sector – as a result of interdependencies and the converging effect of regulatory creep – gave rise to the demand for a new diversity of off-balance-sheet methods to manage assets and credit. In particular, post the Enron scandal stricter regulations introduced to control off-balance-sheet activity resulted in an explosion in special purpose vehicles created to bypass a culture where stifling regulation presented a massive competitive advantage to those institutions able to reap the benefits of economies of scale.

Nevertheless whilst I believe it is wholly wrong to bury hedge funds, we should be wary of giving them too much praise. There is no doubt that the emergence – in reaction to regulatory overkill – of a largely unpoliced, unsupervised hedge fund sector had significant distorting effects on the entire financial system.

Additionally the huge, largely unregulated profits derived by the most successful hedge funds has had perverse effects on the strategies employed by investment banks whose profits could never emulate those obtained in the tax-free, regulation-lite regimes enjoyed by the funds. As these profit margins became ever more the talk of the City, unrealistic expectations as to compensation were ratcheted up. By 2004 senior banking executives watched enviously as hedge funds’ profits soared and their brightest and best junior staff were poached to make their fortunes there. In retaliation many leading investment banks elected to allow the emergence internally of ‘virtual fund’ teams specialising in the riskiest but potentially highest return sectors. More often than not such ‘star’ teams negotiated – and were granted – special shadow profit-sharing status internally. This was the worst of all worlds – giving such teams the green light to indulge in unprecedented risk-taking all the time underwritten by the banks’ colossal balance sheets. This seemingly safe umbrella encouraged ever greater leverage and the spectacle – even in the good times – of such a small proportion of banks’ profits being retained. Naturally this strategy was only questioned after the credit crisis exposed the folly of allowing the inherently riskier culture of hedge funds to pollute the banking system.

I believe it is right that policymakers engage intellectually with the proposition that rewards (and super profits) be justified only in return for exceptional performance rather than as an arbitrage for tax and regulatory breaks. This requires a systematic analysis of the structure of the financial services sector. Scapegoating hedge funds and private equity cannot be a sensible first step down this path.