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London at the crossroads as hedge fund industry ponders the future

Reeling from a double whammy of losses last year that averaged nearly 20 per cent across the global industry and a wave of redemptions by investors disappointed by performance or in urgent need of

Reeling from a double whammy of losses last year that averaged nearly 20 per cent across the global industry and a wave of redemptions by investors disappointed by performance or in urgent need of liquidity, assailed by media and politicians for whom alternative investment managers represent a convenient scapegoat for the global credit meltdown, and apparently threatened by a new wave of tough regulation, London’s hedge fund industry might be forgiven for seeing only a bleak outlook for the new year.

But the industry’s principal European centre shows no sign of yielding its dominance any time soon. Asset bases may be shrinking and some funds and managers shutting up shop, but service providers say there is a significant line of new hedge funds being launched to take advantage of a market conditions that could yield outsized profits to the brave and the skilled. Service providers that have a solid business and good reputation look forward to a flight to quality as investors for the first time turn a critical eye on the calibre of the infrastructure managers have put in place.

The wave of redemptions over the past six months may have taken some of the lustre from the hedge fund industry, but not its rationale. Seasoned observers such as Nick Roe, the London-based head of prime finance at Citigroup, believe that institutional investors will soon be returning to the alternative market with more capital than ever – not least because the alternatives are unattractive, with interest rates at historic lows and equity markets nursing losses as much as double those suffered by hedge funds.

The UK as a jurisdiction has been in the firing line in recent times, with managers reported to be considering quitting in droves over issues such as the taxation of non-domiciled individuals and uncertainty about the tax treatment of offshore fund structures. Yet for all the headline-grabbing reports of managers setting up shop in the Channel Islands, the Isle of Man, Monaco or Geneva, there’s little sign of the kind of mass exodus predicted by the doomsayers.

And for all the fears of a knee-jerk reaction to the credit crisis that might involve the imposition of damaging levels of public transparency, or constraints on strategy or investment techniques such as short selling, industry representatives believe they are making headway with efforts to educate decision-makers about how hedge funds operate and their true role in national and global financial systems.

Particularly in the wake of the Bernard Madoff case, there is increasing confidence that the Financial Services Authority’s approach to regulation of hedge fund managers not only will be considered satisfactory in the new market environment but that it offers a useful template for those jurisdictions – notably the US – where there is a consensus that oversight of the industry genuinely needs improvement.

Following last year’s Senate hearings in Washington attended by luminaries of the US hedge fund industry, on January 27 it was the turn of London-based managers and industry representatives to respond to the invitation of the House of Commons Treasury select committee. They faced at times hostile questioning from members of parliament on issues such as the role played by short sellers in the stock market collapse of Britain’s banks, and the slowness of managers to sign up to the self-regulatory principles drawn-up by the Hedge Funds Standards Board.

The previous day the Alternative Investment Management Association had got in a pre-emptive strike by reporting that directly and indirectly, the hedge fund industry employed some 40,000 people in the UK, mostly in and around London. In addition to the 10,000 employees of hedge fund management firms, of which there are reckoned to be around 500 in London, Aima says at least 30,000 jobs among advisers and service providers such as prime brokers, law and accountancy firms and fund administrators are dependent on the industry.

The industry participants at the committee hearing were Marshall Wace chairman Ian Marshall, Doug Shaw, head of alternatives at BlackRock, chief executive Chris Hohn of The Children’s Investment Fund Management and Stephen Zimmerman, chairman of NewSmith Asset Management, as well as Aima chief executive Andrew Baker.

They insisted that any impact of short selling on banks’ share prices was far outweighed by that of long-only investors fleeing stocks in which they had lost faith because of growing doubts over the quality of their assets. The managers insisted that the regulatory system operated by the FSA, which applies to managers of both hedge funds and traditional investment vehicles, has proved fully suitable to the task, arguing that it might well have hindered the perpetration of a mammoth Ponzi scheme like that of Madoff.

Baker hopes that the managers’ performance in what was a unique public presentation for the industry (although private equity executives were grilled by the same committee last year) has started to demystify hedge funds in the minds of politicians and the public, and that it will lessen the likelihood of ill-considered changes to regulatory and transparency requirements being imposed as a knee-jerk reaction to the crisis.

‘We’ve all in favour of good regulation, because good regulation is good business,’ he says. ‘But hopefully the idea that whenever there’s a problem, it must be because there’s not enough regulation, won’t gain too much traction. Just layering up on the rulebook is not necessarily going to help anyone.

‘Madoff was a fraud, and no amount of regulation on this planet can be fully effective against fraud. Nevertheless we feel that hedge fund managers should be authorised by their local regulator, which is a recognition that what’s going on in the US [registration of managers with the Securities and Exchange Commission is currently voluntary] probably needs to be made compulsory. We also need a common international approach on short selling, involving some kind of restriction on naked shorting selling and a uniform disclosure regime.’

Baker and his colleagues would be happy to see the FSA’s approach adopted worldwide. ‘It’s an excellent template,’ he says. ‘It has three elements, the upfront authorisation of the manager, which is very rigorous; an approved person’s regime involving a ‘fit and proper’ register, which means people have to be suitably qualified and pass the ‘sniff test’; and a specialist unit capable of monitoring the bigger players with systemic significance. We think that’s a very powerful combination.’

He defends the Hedge Fund Standards Board against scorn that a year after the launch of the initiative to encourage managers to adopt common standards voluntary, only 34 had signed up to the code of practice. ‘You’ve got to give it time to work,’ Baker says. ‘It’s a comparatively recent initiative – managers only had to conform to the standards as of December 31, so beating them up as of January 27 is slightly unfair.’

He notes that some managers that have expressed reluctance to sign up to the standard formally do in fact adhere to them in practice, attributing their reticence to ‘the burden attached to having to provide third-party authentication’, especially for firms with a range of investment businesses. But he believes that some initially hesitant members of the industry may have changed their minds about signing up to the standards as a result of the public pressure on the industry. Hohn told the Commons committee that TCI was in the process of adhering.

Baker is bullish about London’s position as a centre for hedge fund management despite the depredations of the past year’s market performance. However, he notes that the problems associated with the insolvency of the London-based Lehman Brothers International (Europe) did represent a black mark for the jurisdiction, as US managers with assets trapped in the administration process drew unfavourable comparison with bankruptcy procedures on the other side of the Atlantic. ‘What happened to Lehman represented a blow to London’s reputation,’ he says.

He is echoed by Roe, who notes that in the wake of the collapse, Citigroup had to reassure clients who were concerned about the perceived risks of doing business in London. ‘From a US perspective, the insolvency laws in the UK were a concern,’ he says. ‘People worried about the UK broker-dealer aspect asked whether we could give any guarantees from our parent, and what those guarantees actually meant. They also asked whether it was possible for US funds to do all their international business through the US broker-dealer.’

However, Roe believes any damage to London as a jurisdiction was probably short-term in nature. ‘If the insolvency laws [can be amended] and if regulators play a more active rather than reactive role, that would help. But from a global perspective London is more highly regulated as a hedge fund centre than any other around the world, and the problems mostly involved things beyond the fund world’s control.’

Baker adds: ‘We’ve been here many times before in terms of potential threats to London’s position. Clearly all kinds of measures need to be taken not just in our industry but right across the financial services industry, from infrastructure to changes to the bankruptcy law, from recovery of the banking system to making sure there is no further tinkering with the personal tax regime. All these things are important in the eyes of potentially footloose international managers.’

Efforts are already underway to see how the UK bankruptcy provisions can be adapted to ensure they do not inflict collateral damage on the financial services industry in future. ‘Our existing bankruptcy code is very good at dealing with a widget manufacturer dealing in tangible assets, but once you get into the intangible arena and across borders it gets much harder,’ Baker says. ‘A Treasury review is underway at the moment to which we have had input. Two very important measures are needed, a short-term fix so that if, God forbid, another Lehman happened, the bankruptcy would be handled in a different way, and a longer-term fix, to come up with a bankruptcy code that can cope with a global financial supermarket.’

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