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Alternative Investment Vehicles & (Self)-Regulation (di Marco Lamandini)

Articoli Correlati: alternative - investments - vehicles - self - regulation


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In a recent discussion on how and why to regulate hedge funds from a US perspective, Professor Paredes [1] – having correctly acknowledged that hedge funds promote market efficiency, add liquidity to the financial markets, provide opportunities for businesses and investors to shift and manage risk and act as shock absorbers that can stabilize financial markets during crisis but, at the same time, may propagate systemic risk – summarized four basic choices: (1) do nothing; (2) substantively regulate hedge funds directly; (3) regulate hedge fund managers, and (4) regulate hedge fund investors. The last approach, complemented with a new anti-fraud provision, was finally adopted by the S.E.C. after the Court of Appeal for the District of Columbia vacated, on June 23, 2006, in Goldstein the then newly enacted Hedge Fund Rule which (under the third possible approach in the above list) attempted on the contrary to regulate hedge fund managers as Investment Advisers under the Investors Advisers Act of 1940 (by considering the hedge fund investors as clients of the fund manager).


Indeed, the regime following Goldstein, on one hand, brought about a new anti-fraud provision which “prohibits advisers to pooled investment vehicles from making false or misleading statements to, or otherwise defrauding, investors or prospective investors in those pooled vehicles”, whereby conferring clear authority to the Commission to bring enforcement actions against investment advisors who defraud investors in a hedge fund or in any other pooled investment vehicle (thereby providing a legal basis for their market integrity control); on the other hand, such new regime revised the requirements for determining whether an individual is eligible to invest in certain pooled investment vehicles, thereby introducing the new “accredited natural person” category designed to ensure, through the increase of the parameters of investor wealth (untouched since 1982, despite inflation, and now set at 2,5 million in investments), that investors in these types of funds are capable of evaluating and bearing the risks of their investments. Alongside with these innovations, which in the words of the Commission, “have the potential to enhance substantially the protection for investors and potential investors in hedge funds and other similar funds”, the U.S. confirmed their reliance in principle to market discipline: a market discipline guided and closely monitored, though.


In fact, in February 2007 the President Working Group on Financial Markets (which had already issued a first set of recommendations in 1999 in the wake of the near collapse of the Long-Term Capital Management fund, noting that “in our market-based economy, market discipline of risk taking is the rule and government regulation is the exception” but also warning that, if market participants had not effectively followed the suggested measures, “there are several matters that could be given further consideration”) issued a set of illustrative “soft law” principles and guidelines “regarding private pools of capital”. These principles cover both investor protection and systemic risks worries. According to Principle no. 2 “market discipline most effectively addresses systemic risk posed by private pools of capital. Supervisors should however use their existing authorities with respect to creditors, counterparts, investors and fiduciaries – thus, through the so called indirect regulation and supervision – to foster market discipline on private pools of capital. Investor protection concerns can be addressed most effectively through a combination of market discipline and regulatory policies that limit direct investment in such pools to more sophisticated investors”. Under Principle no. 4 “investors in private pools of capital should obtain accurate and timely historical and ongoing material information necessary to perform due diligence regarding the pool’s strategies, terms, conditions and risk management, thereby enabling such investors to make informed investment decisions” (this principle is then detailed in 5 derivative rules). Under Principle no. 5 concerns (brought about by recent retailisation of hedge funds) that less sophisticated investors could be exposed indirectly to private pools through holdings of pension funds, fund of funds, or other similar pooled investment vehicles should be governed again through indirect regulation and supervision and “can best be addressed though sound practices on the part of the fiduciary that manage such vehicles. These fiduciaries have a duty under applicable law to act in the best interest of the beneficiaries. They have an ongoing responsibility to perform due diligence to ensure that their investment decisions are prudent and conform to sound practices for fiduciaries”. As to systemic risks, given the premise that [continua ..]


In the literature, especially in the U.S., views are still inclining to support a light touch in the regulation. Only to mention a few recent studies, Cumming & Que (2007) [3], considering an international dataset of 2937 hedge funds from 24 countries around the world, find that – although “a lack of regulatory oversight may give rise to fund managers that disguise investment schemes and merely capture the fees” – data seem to suggest that “regulatory requirements in the form of minimum capitalization, restrictions on the location of key service providers and restriction that limit distributions to private placements tend to be associated with lower fund alphas, lower manipulation-proof performance measures, lower average returns, higher fixed fees and lower performance fees”. Oesterle (2006) [4] concludes that “extensive direct regulation of hedge funds is unnecessary and may harm the country’s trading markets. Indeed the dramatic growth of hedge funds is in part attributable to the current overregulation of registered investment companies. We should therefore not tighten the regulation of hedge funds but lighten the regulation of registered investment companies, strengthening however some forms of indirect regulation of hedge funds leverage, principally limits on banks that lend to and are counterparties of hedge funds”. Kambhu, Schuermann and Stiroh (2007) [5], whilst recognizing that “market participant may not be sufficiently cognizant of the risks they face and therefore not vigilant enough in constraining counterparty risk” and that “systemic risk reflects an externality or public good problem, that by definition even well informed market participants will not have an incentive to adequately monitor or limit those risk-generating actions and that therefore there is a role for regulation to reduce inefficient systemic risk”, they conclude however that “the current emphasis on market discipline and counterparty credit risk management as the primary check on hedge fund risk taking is appropriate”. The authors believe that outright regulation of hedge funds is not advisable: “activity restrictions that dramatically limit trading strategies such as short selling or the use of derivatives would likely diminish the beneficial impact of hedge funds on market liquidity and price discovery. Required capital ratio would be difficult to set [continua ..]


As a matter of fact, in the European context there is no unified regulatory framework for alternative investment vehicles. As it has been pointed out by the recent Naik Report (2007), correctly stressing the very many anomalies existing in the current regulatory practice [11], whilst qualified investors can invest in hedge funds by way of private placement but they do so without national or EU investor protection measures to support them and UCITS III funds (now enabled to use some alternative investment strategies) can be offered cross-border to retail clients without investment expertise, “in the middle there is a market of non-harmonized funds. It is through non-harmonized investment products that most investors gain access to hedge funds (and other alternative investment vehicles) and it is here that regulation across the EU is fragmented and confusing. National regulators have adopted different frameworks. Some differences are small. Others are more material but each difference raises the costs of providing investment services across Europe”. Private pools of capital do not benefit, therefore, of the European passport and, in principle, are not able to market their products across Europe (unless they abide by all different national rules applicable in each host MS). On one side, therefore, the regulatory debate focuses on the need to harmonize such divergent national regimes in order to foster pan-European market integration in this respect, overcoming existing national fragmentation. The Commission called, already in its Green Paper on the Enhancement of the EU Framework for Investment Funds [12], for a “coherent and enlightened European approach to this sector”, envisaging “a common regulatory approach to facilitate the further development of European markets for hedge funds and private equity funds”, possibly devising common rules also on the “private placement” notion which could facilitate the cross border offer to qualified investors [13]. The Council, in turn, has requested in May 2007 a report, expected by mid 2008, from the Commission on possible measures to be taken on a Single Market framework for the retail-oriented non harmonized fund industry, which might include some funds of hedge funds. The European Parliament, with the Parvis resolution first and with the Van den Burg Report [14] later, called, on the other side, for attention to the “gaps in disclosure [continua ..]

6 .

These latter concerns are tackled today in a quite differentiated way among jurisdictions [15], but mostly through indirect regulation and supervision (especially from the banking side) and self-regulation. In particular, in London where most of the European managers of the industry are located and registered, this is done through a wide array of self-regulatory measures within the general principles of supervision of FSA (namely, the “Principles” for authorized firms and those for individuals; the rules on “Senior Management Arrangements, Systems and Controls”; the “Code of Market Conduct” and the “Conduct of Business Sourcebook”). In fact, the FSA accepts that funds be lightly regulated off-shore but regulate the managers and their activity in the U.K. The FSA philosophy is finely described in a position paper issued on March 2006 [16]: FSA is fully aware of the risks of regulatory competition in the field and finds that it would be counter productive to increase the burden of regulation if it could result in managers moving off-shore to more lightly regulated locations. It established, though, a dedicated supervision team: a) first to monitor on an on going basis identified risks (such as market abuse, anti-money laundering, the control of operational risks, managing conflicts of interest but also valuation of assets, where FSA explicitly supports the IOSCO principles [17] “for the valuation of hedge fund portfolios”) and b) second, to review on a regular basis also those prime brokers that do have exposures to hedge funds. The supervisory approach is also careful in differentiating hedge fund managers from traditional asset managers and private equity/venture capital funds. As regards transparency vis à vis the investors, the FSA addresses specifically, for instance, the issue of side letters and states that “at a minimum would expect acceptable market practice to be for managers to ensure that all investors are informed when a side letter is granted”. This finding is well illustrative of the way a principle-based supervision grounded on market practices work in practice and could usefully replicated at the EU level: the FSA is encouraging the industry to develop a consistent market practice, warning at the same time that failure to disclose the existence of side letters would be in breach of Principle 1 of the Principles for Businesses (“a firm must [continua ..]


In this context, there seem to be room for a coherent EC re-adjustment of the existing inconsistent regulatory patchwork on alternative investment vehicles which, however, should, also in my view, confirm reliance also on self-regualtory best practices and refrain from any regulatory disproportionate step which could reduce innovation (also unnecessarily banning or limiting aggressive investment strategies or alternative funds’ activism as shareholders, which, as also shown by the recent OECD Report (2007) [20] is to be considered generally beneficial), increase cost, adversely affect the derivative market and prompt a relocation of alternative investment vehicles off-shore. On the contrary, such re-adjustment should be so devised as to contribute to attract more investors by establishing adequate transparency standards and to increase liquidity by bringing about a real single market in lieu of the existing national fragmentation.


To this purpose, taking account of the existing bifurcation of the hedge fund sector (boutiques and institutional oriented firms) following the Naik Report recommendations, alternative investment vehicles like properly diversified funds of hedge funds could be allowed to benefit of the UCITS III regime and a higher degree of cross-border retailisation, with the additional provision (as to the interplay between regulation and self-regulation) that they can invest only in funds – off-shore or on shore – that comply with recognized codes of conducts so as to provide strong market incentives to voluntary compliance. All other alternative investment vehicles should be subject to harmonized and proportionate minimum registration requirements coupled with MiFID or MiFID-like (or FSA-like) general principles for their management, under a principle based approach differentiating between the specific features of hedge fund, private equity and venture capital industries. This could not only pave the way towards mutual recognition and a coherent level playing field across Europe but, at the same time, towards an effective supervision extensively grounded, in addition to indirect supervision on banks and prime brokers through appropriate risk management (already grounded in the Basle II Accord and Capital Requirement Directive) [21], on best market practices and self-regulatory codes of conduct. In other terms, single market reasons, self discipline and proportionate and principle-based supervision aimed at investor, market integrity and financial system protection should converge fostering at the same time the cross-border growth of the industry and its transparency and soundness (to avert systemic risk). As recently pointed out by the de Vries and Stork Report (2007) [22] “high levels of transparency on issues like the fee structure, the redemption policy, the valuation procedure, the investment strategy and result reporting are obvious. Better transparency on these issues is one of the main instruments to make market discipline effective and for preventing systemic disruptions” [23]. In turn, the CESR activity under the Lamfalussy procedure, if called into action here, should prove useful, in my view, to facilitate convergence of national supervisors not only to solve long lasting anomalies depending on the existing national fragmentation of the regulatory framework (providing e.g. a common definition of private [continua ..]