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The web site itself may have changed. You can check the current page or check for previous versions at the Internet Archive. Yahoo! is not affiliated with the authors of this page or responsible for its content. Harvard Law School Proposals for Reform of Hedge Fund Regulation Submitted to Professor H. Scott Harvard Law School Proposals for Reform of Hedge Fund Regulation
Submitted to Professor H. Scott in fulfillment of the LLM Written Work Requirement
By Anthony P. Hanlon
Cambridge, Massachusetts April 24, 2002 Anthony Hanlon Page 3 of 113 Contents Section Page Summary 5 One: Definitions 7 A. Hedge Funds: In Theory 7 B. Hedge Funds: In Practice 11 C. Conclusion 13 Two: The Market 14 A. Overview 14 B. Buyers of Hedge Funds 15 C. Providers of Hedge Funds 19 D. Conclusion 21 Three: Investment Techniques 23 A. The Nature of Bank and Mutual Fund Assets and Liabilities 23 B. The Nature of Hedge Fund Assets and Liabilities 24 C. Long Term Capital Management 33 D. Conclusion 34 Four: The Position of Hedge Funds in the US Regulatory Framework 35 A. The Objectives of Securities Regulation 35 B. Exemptions from Regulation 37 C. Public Fund Regulation and Hedge Funds 41 D. Conclusion on Investor Protection Issues 61 E. Market Efficiency, Transparency and Fairness 64 F. Conclusion 67 Anthony Hanlon Page 4 of 113 Contents (continued) Five: Policy Issues Raised by the Regulatory Status of Hedge Funds 68 A. Definition of Systemic Risk 68 B. Review of Issues Raised By the LTCM Crisis 69 C. Discussion 84 D. Policy Responses In the Wake of the LTCM Crisis 91 E. Discussion 99 F. Conclusion 101 Six: Recommendations 102 A. Characteristics of the party subject to a disclosure obligations 102 B. Who meets these criteria? 102 C. What information must be provided, to whom and how often? 108 D. Conclusion 111 Bibliography 113 Anthony Hanlon Page 5 of 113 Summary Hedge funds are unregulated, offshore mutual funds, owned by sophisticated investors and subject to limited disclosure requirements. They use their deregulated status to concentrate risk and utilize leverage to magnify risk. Formerly, hedge fund investing was limited to a handful of wealthy individuals: but US financial institutions now allocate a growing percentage of their assets to investments in hedge funds. This has fuelled strong growth in capital invested in hedge funds, which now amounts to approximately $600bn; using conservative assumptions, total capital could reach $1 trillion within two or three years. The widespread use of short selling techniques and over the counter derivatives allow hedge funds to assume levels of risk and to adopt positions in financial markets which can be measured in multiples of their base capital. But these techniques result in balance sheets as highly leveraged and vulnerable to shocks as those of banks. US federal securities regulation draws a distinction between investment funds sold to sophisticated investors and those sold to the public. Private investment funds are largely exempt from federal regulation and most hedge funds adopt this format. Public investments funds are subject to detailed regulation and oversight. This paper argues only two of the public fund regulations are inconsistent with hedge fund investment techniques those concerning diversification and leverage. These provisions were designed to address issues which were important in the 1930s, but are largely irrelevant today. The collapse of Long Term Capital Management in September 1998 highlighted that hedge fund secrecy is a potential source of systemic risk. The Presidents Working Group on Financial Markets has proposed that hedge funds provide better information to their transaction counterparties. This policy does not address the core problem and has potentially damaging side effects: instead, public disclosure of information on individual funds is required. Anthony Hanlon Page 6 of 113 US public fund regulation should adjust to encourage hedge funds to operate within the framework of the Investment Company Act of 1940. In addition, disclosure obligations about individual hedge funds should be imposed on the prime broker: the prime broker should disclose for each fund (1) the aggregate notional positions by market and (2) measures of solvency. This data should be disclosed monthly with an exemption for all hedge funds with total positions under $100m. Anthony Hanlon Page 7 of 113 Section 1: Definition A. Hedge Funds: In Theory Hedge fund is a loosely used term. No statutory or judicial definition exists. Given, the emphasis of US securities law on limiting what securities may be offered to the public, the Presidents Working Group on Financial Markets 1 (the Working Group) started its examination by analyzing hedge fund investors:
Although it is not statutorily defined, the term [hedge fund] encompasses any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public. The primary investors in hedge funds are wealthy individuals and institutional investors. In addition, hedge fund managers frequently have a stake in the funds they manage. 2 . The General Accounting Office 3 reflected the approach of the Working Group: it chose to highlight what position hedge funds occupied in the regulatory structure of the United States. Hedge fund, though not legally defined, is the term used to loosely refer to an investment fund structured to be exempt from certain investor protection requirements and thus able to follow a flexible investment strategy. Hedge funds, which are often exempt from the Investment Company Act and some (but not all) reporting 1 Hedge Funds, Leverage and the Lessons of Long Term Capital Management Report of the Presidents Working Group on Financial Markets, April 1999 hereinafter The Working
Group Report Available at http://www.ustreas.gov/press/releases/docs/hedgfund.pdf 2 The Working Group Report at page 1. 3 Long Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk, United States General Accounting Office, October 1999 hereinafter The GOA Report. Available at http://www.gao.gov/archive/2000/gg00003.pdf Anthony Hanlon Page 8 of 113 requirements under the Commodities Exchange Act, are different from registered investment vehicles, such as mutual funds, in several important ways. Hedge fund managers are able to (1) invest in any type of asset in any market, (2) use many investment strategies at the same time, (3) switch investment strategies quickly, and (4) borrow money and/or otherwise use leverage without being subject to investment company leverage limits. Compared to commercial banks, which had about four times as many assets, and mutual funds, which had five times as many, hedge funds are relatively small 4 . The Working Group also commented upon investment techniques: [hedge funds] are able to sell securities short and to buy securities on leverage. While this activity is not unique to hedge funds, hedge funds often use leverage aggressively Hedge funds are also diverse in their use of different types of financial instruments. Many hedge funds trade equity or fixed income securities, taking either long or short positions, or sometimes both simultaneously 5 . The Bank of International Settlements 6 (The Basel Committee) focused upon those characteristics affecting the interaction between hedge funds and banks. These included lack of regulatory oversight, limited disclosure and the use of leverage. It adopted the term Highly Leveraged Institution (HLI) : 4 The GOA Report at page 38 5 The Working Group Report at page 2 6 Banks Interactions with Highly Leveraged Institutions, Basle Committee on Banking Supervision January 1999 hereinafter the Basel Report
Available at http://www.bis.org/publ/bcbs45.pdf
Anthony Hanlon Page 9 of 113 It is difficult to provide a precise definition of a highly leveraged institution. For the purpose of this paper, the focus is on those types of large financial institutions that generally have a combination of the following attributes First, they are subject to very little or no direct regulatory oversight.Second, the HLIs considered in this paper are generally subject to very limited disclosure requirementsThird, such institutions often take on significant leverage, where leverage is the ratio between risk, expressed in some common denominator, and capital 7 . The Basel Committee also commented on trading strategies: much of the leverage of HLIs is created through the types of trading strategies undertaken and the transaction terms they receive from their counterparties. 8 The International Organization of Securities Commissions 9 (IOSCO) broadly accepted the definition used by the Basel Committee; but chose to highlight trading activities and the adoption of offshore jurisdictions. HLIs are, for the purposes of this paper, institutions which are significant traders for their own account in financial instruments and which display a combination of the following characteristics : (i) they take on significant leverage; (i) they are subject to little or no direct prudential regulation; (ii) they are subject to limited disclosure requirements as they are seldom public companies. 7 The Basel Report at page 8 8 The Basel Report at page 8 9 Hedge Funds and Other Highly Leveraged Institutions, International Organization of Securities Commissions hereinafter The IOSCO Report. Available at http://www.iosco.org/docs-public/1999- hedge_funds.html Anthony Hanlon Page 10 of 113 (iii) They are often organised in or operate from or through offshore jurisdictions that may be regulatory or tax havens 10 . IOSCO later states: The combination of size, leverage and ability to take very concentrated positions means that the trading activities of certain HLIs may have an effect on markets, even under normal market conditions 11 . Investment industry participants tend to distinguishing hedge funds from other forms of investments by emphasizing their high risk investment strategies. Ervin 12 makes the following observation about hedge funds: In fact, hedging is neither the purpose nor the nor the normal practice of hedge funds, which are more aptly characterized as speculative trading vehicles that take positions designed not to offset risk created by existing investments but to assume calculated risk in pursuit of above average gains. Lavinio 13 also emphasizes the broad range of investment tactics used by hedge funds: [Hedge Funds] stated objective is to generate above average returns for their investorsbecause their mandates are not restricted to plain buy and hold commodity, equity and fixed income investments, hedge funds are often called alternative investment vehicles Because they are not restricted to buy and hold investment strategies, most hedge funds seek to generate their returns by using some or all of the following techniques: short 10 The IOSCO Report at 5 and 6 11 The IOSCO Report at 16 12 Hedge Funds in the 1990s published in Kirsch, The Financial Services Revolution, chapter 16, Irwin Professional Publishing 1997 13 Lavinio , The Hedge Fund Handbook McGraw-Hill 2000. Pages 1-3 Anthony Hanlon Page 11 of 113 sellinghedgingarbitrageleveragingsynthetic positions or derivatives. in exchange for lower or no regulation, such vehicles tend to be restricted to sophisticated and/or wealthy investorsand for this reason tend to have high minimum investment levels. 14 Crerend observes: However expansive the term, hedge fund investing remains essentially the same. That is, you are long something because you believe the price will rise and short something because you believe the price will decline, and if you are really certain, you will borrow money to do either or both 15 The Economist 16 elaborated [O]ne of the few common characteristics of hedge funds is their aristocratic focus on absolute returns: the notion you can make money even if there is a bear market in stocks or bonds. B. Hedge Funds in Practice Van Hedge Funds Associates 17 , a private sector hedge fund database summarized the characteristics of the average hedge see table one. It highlights : 1. Hedge funds are small: the median fund size is only $22m 2. Hedge funds have limited track records: the median fund age is 5.3 years. 3. Hedge fund managers have extensive industry experience - 15 years on average. 14 Lavinio, supra, at page 157 15 Crerend Fundamentals of Hedge Fund Investment McGraw Hill 1998, page 1. 16 The Economist, Spetember 1 st -7 th 2001, page 60: Measuring hedge funds: the benchmarking bane 17 Available at http://www.vanhedge.com/index.htm Anthony Hanlon Page 12 of 113 4. Hedge fund management fees are high: the median is 1% of assets under management plus 20% of any gains relative to a stated objective (often termed a high water mark). Table One Global Hedge Fund Characteristics As at 4Q1999 Mean Median Mode Fund size $87m $22m $10m Fund age 5.9 years 5.3 years 5.0 years Minimum investment required $695,000 $250,000 $250,000 Number of entry dates 34 12 12 Number of exit dates 28 4 4 Management fee 1.70% 1.00% 1.00% Performance allocation ("fee") 15.90% 20.00% 20.00% Manager's Experience: In securities industry 17 years 15 years 10 years In portfolio management 11 years 10 years 10 years Yes Manager is a US registered investment advisor? 45% Fund has hurdle rate 17% Fund has high water mark 75% Fund has audited financial statements or audited perf 98% Manager has $500,000 of own money in fund 75% Fund is diversified 57% Fund can short sell 84% Fund can use leverage 72% Fund uses derivatives for hedging only, or none 72% Source: VAN hedge Fund Advisors International Anthony Hanlon Page 13 of 113 C. Conclusion Summarizing these characteristics, it is possible to adopt identify hedge funds as investment schemes which: 1. Are utilized by sophisticated investors. 2. Pursue risk through (i) concentrated portfolios (ii) strategies derived from complex mathematical models (iii) intensive short term trading activity (iv) extensive use of derivatives 3. Use of leverage to magnify risk. 4. Make limited disclosure to market participants and regulators. 5. Adopt legal residence in offshore jurisdictions. Hedge funds form part of the unregulated financial markets to which the euro-deposits, eurobonds and over the counter derivatives (swaps) markets belong. This raises three questions: (1) is the unregulated mutual fund market as important as the other unregulated financial markets: (2) why do hedge funds seek unregulated status and (3) what policy issues arise from the unregulated status of hedge funds? Section two examines the size of the hedge fund market and section three discusses what implications arise from the growing amount of capital at their disposal. Section four reviews the position occupied by hedge funds under U.S. regulations to discuss why they seek unregulated status. Section five discusses what policy issues arise from current regulatory status of hedge funds. Section six sets out proposals for reform.
Anthony Hanlon Page 14 of 113 Section Two The Market for Hedge Funds A. Overview In September 2001, the Economist 18 published an article headed Hedge funds: The Latest Bubble? It noted that in the first half of 2001, almost twice as much money flowed into hedge funds as in the whole of 2000. Chart One: The Size of the Hedge Fund Market 19 Growth of Assets and Number of Funds 0 100 200 300 400 500 600 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year 0 1000 2000 3000 4000 5000 6000 7000 No. of Funds $ under management (bn) No of funds Chart one illustrates the rapid growth of hedge funds in recent years. The LTCM fiasco notwithstanding, hedge funds assets grew rapidly in 2000. Forecasting the size of the market is a function of three variables:
18 The Economist, September 1 st -7 th 2001, Page 59, Hedge Funds, The Latest Bubble? 19 Source: Van Hedge Fund Associates, available at http://www.vanhedge.com/index.htm Anthony Hanlon Page 15 of 113 (1) Determining who future buyers of hedge funds might be (2) Estimating the value assets these buyers have available for investment (3) Estimating what percentage of these assets might be allocated to hedge funds. Obtaining accurate data on hedge funds when no central source exists is difficult: the following overview of the market is obtained from a survey conducted in March 2001. In addition to published sources, extensive interviews were carried out with prime brokers in the US and the UK, and professional advisers to hedge funds accountants and lawyers. B. Buyers of Hedge Funds Chart Two summarizes the current ownership of hedge funds: ownership is divided between wealthy individuals (High Net Worth Individuals or HNWI) and institutions. At present there is no mass retail market. Chart Two Current Structure of Hedge Fund Market US Insurance 1% US pensions 4% US HNWI 42% US non- profit 18% Europe insurance 1% Europe pensions 0% Europe HNWI 34% Source: Van Hedge Fund Advisors, 1999 Anthony Hanlon Page 16 of 113 (1) HNWI Wealthy individuals (High Net Worth Individuals or HNWI) individuals with assets in excess of US$ 1 million - account for over 60% of the approximately $600bn invested in hedge funds. There are signs that hedge funds are becoming a standard element in HNWI not just super wealthy portfolios. In Switzerland, anecdotal evidence suggests private banks now recommend investing up to 30% of assets in alternative investments. And in the UK, a leading wealth manager recently announced it was recommending up to 25% of client assets in alternative investments. In the US, advisors recommend anywhere from 10-40%. (2) Institutions Table two: asset allocation amongst leading US university endowments Institution Domestic Equity International
Equity Hedge/
Arbitrage Private
Equity Fixed
Income Real
Estate Cash Brown 25 19 18 9 20 4 5 Colgate 37 11 14 7 23 3 5 Columbia 25 12 18 22 9 6 8 Cornell 42 10 16 5 23 3 1 Dartmouth 35 15 7 18 14 7 4 Davidson 43 12 3 11 20 9 2 Duke 15 14 25 28 12 6 0 Furman 34 20 9 7 19 8 3 Harvard 22 22 10 16 16 8 6 Princeton 16 15 24 22 12 8 3 Stanford 27 22 9 15 9 18 0 Vanderbilt 39 19 11 15 11 5 0 Virginia 12 8 25 26 12 9 5 Wake Forest 54 12 4 5 19 4 2 Yale 15 11 21 29 10 13 1 Average 29 15 14 16 15 7 3 U of R
Current Policy 30% 15% 20% 30% 0% 5% 0% Anthony Hanlon Page 17 of 113 Source: Data provided by a leading US foundation with extensive hedge fund investments, derived from survey of similar foundations. Institutions are under-represented amongst investors in hedge funds but now seem to view alternative investments both private equity and hedge funds as a necessary part of portfolio management 20 . A survey by Goldman Sachs and Frank Russell 21 suggests that the average US plan sponsor anticipates their strategic allocation to alternative investments will rise to 8% over the next three years. Demand can be simply estimated by multiplying the total assets held by institutions by target percentage weighting. Table three: Potential for US institutional investment in hedge funds 22 Total assets in 2000 in $ billion Amount available for hedge fund investments assuming 8% allocation Pension plans $7,674 $614 Insurance Companies $4,000 $320 Mutual Funds $6,200 $496 Total $17,874 $1,430 The adoption of these investment targets by US institutions could produce demand equal to $1,430bn. While investment in hedge funds on this scale is extremely unlikely in the near term, this analysis indicates the potential. European institutions have much lower weightings to alternative investments than US counterparts and the rate of take up does appear to be much slower. But even modest changes in policy 20 Watson Wyatt / INDOCAM - Alternative investment review relating to the continental European marketplace, 2000 and Watson Wyatt / INDOCAM - Alternative investment review relating to the North
American marketplace, 2000 21 Cited in the Indocam survey, supra 22 Source: Jackson, Regulation of Financial Institutions chapter 3, page 9 Anthony Hanlon Page 18 of 113 could increase demand amongst European institutions from the current US$8bn to US$40-50bn. The hedge fund industry currently lacks the key building blocks needed to develop an institutional product education of clients, distribution, institutional marketing, transparency around process and valuations, large scale manufacturing capacity, among managers and sophisticated after-sales service 23 . But the investment management industry is full of precedents - equity fund management, international fund management, emerging markets fund management where it has rapidly addressed these deficits. The rate of growth in the institutional sector hinges on the ability of the industry (1) to build an effective distribution mechanism which educates clients and (2) to build an effective platform capable of managing hedge fund assets on the scale required by institutions. The precise rate of take up incorporated into any forecast hinges on the speed at which the investment management industry delivers these solutions. (3) Mass retail market Hedge funds limited to sophisticated investors - are not available to the general public. Attempts by the industry to launch them have tended to meet effective resistance from regulators. The unregulated nature of hedge funds precludes the development of a mass retail market along the lines of the mutual fund industry. Regulators show little signs of softening their attitude. (4) Summary Demand for hedge funds could grow from $600bn to $1,000bn over the next two or three years under fairly undemanding assumptions i.e that HWNI invest at the same rate and that US institutions invest no more than 2.5% of assets in hedge funds and European institutions increase exposure to $50bn. The fastest growing segments are likely to be be: 23 Indocam survey, supra Anthony Hanlon Page 19 of 113 1. The mid level HNWI market in the UK and the USA. 2. Pension plans in the USA. 3. Institutions in the UK, Switzerland, Sweden and the Netherlands
C. Providers of Hedge Funds
Lack of production capacity is the dominant characteristic of the hedge fund industry. This makes itself felt in several ways; 1. Very high fees and very high profitability. The typical hedge fund manager charges a management fee in excess of 1% 24 (versus 40-50 bp on the typical long only portfolio) and usually is entitled to 20% of the profit if a certain target return is exceeded. 2. There are few large scale producers: the largest hedge fund is has US$16bn under management 25 . This compares with the largest pension fund or mutual fund producers who can manage assets exceeding US$100bn. One reason for this is that many hedge fund managers do not believe their techniques could work with large assets under management. They close their funds to new funding once they reach a certain size. Lack of capacity may represent a major break on the growth of the hedge fund industry. 3. The industry is very skewed. The market leaders - about 20 hedge fund groups - have assets in excess of $500m. This implies a very long tail of small funds Van Hedge Fund estimate the average hedge fund is only US$ 25m in size but the high fees and very low costs make operations on a small scale viable. 24 see Table One, supra. 25 Van Hedge Funds database, supra. Anthony Hanlon Page 20 of 113 Chart Three Location of Hedge Fund Managers by Assets 81% 15% 4% USA Europe Other Source: FT, 9 Feb 2001 / Goldman Sachs 4. The vast majority of hedge fund managers are located in North America largely in the New York and Los Angeles areas. But in Europe London particularly- a large number of companies are starting up. Anecdotal evidence suggests US managers are opening in larger scale in London. 5. All legal and accountancy representatives reported that established investment adviser complexes were establishing hedge fund capabilities. Reasons cited for doing so include retaining key staff as well as developing new, high margin business. This may represent an important factor driving growth; many fund management complexes, facing competition from index funds 26 are looking for new, higher margin businesses. 6. The provision of support services covering prime brokerage, custody and fund administration are well established by third party suppliers. The areas where service provision remains very poor is in fund raising, risk management and regulatory compliance. 26 Portfolios which attempt to replicate the performance of market indices such as the Standard and Poors 500 Index. Anthony Hanlon Page 21 of 113 7. Most advisors noted a specific life cycle for hedge funds. New start ups, to be viable, had to raise about $20m. If performance is good the fund re- opens 12 months later and grows to $60-100m. If performance is sustained, a further 12 months on, the fund can re-open and grow to $300-600m. But in practice few funds grow beyond the $25-30m size. 8. The credibility of the investment decision making process is critical to fund- raising. The investment managers must have considerable experience and those with good reputations can raise $250m at launch. Experience in short selling is critical as are robust risk control measures. There are signs that with the amount of institutional money facing the market, standards and expectations on managers are falling. D. Conclusion
The Economist 27 made the following observations: Some people reckon the industry is coming of age: it is growing more sophisticated as it acquires a track record that looks more appalling to investors each time that other asset classes - from shares to venture capital suffer yet another fall. And for all the rapid growth in hedge funds, the scope for more remains. Only one in five high net worth individuals now invests in any form of private equity (which includes venture capital as well as hedge funds)Others are more skeptical.The party poopers are led by Barton Biggs of Morgan Stanley, a veteran investment strategist and bubble spotter. The hedge fund mania in both America and Europe, bears all the signs of a classic bubble. 27 The Economist, supra Anthony Hanlon Page 22 of 113 The picture that emerges is of a large amount of potential demand being supplied by what is essentially a cottage industry. Even if capital invested in hedge funds grows more slowly than forecast - because of capacity constraints - invested capital could feasibly reach $1 trillion within two or three years. This figure is much smaller than e.g. $6-7 trillion dollars currently invested in mutual funds in the United States. It is also small compared with the $7.2 trillion outstanding in the Eurobond 28 and the $99.7 trillion notional amount outstanding in OTC swaps markets 29 The question is whether hedge funds have characteristics which magnify their significance beyond that suggested by the amount of invested capital. Section three discusses this issue. 28 Bank of International Settlements Quarterly Review, March 2002, Statistical Annex Table 11 29 The Bank of International Settlements Quarterly Review, March 2002, Statistical Annex Table 19 Anthony Hanlon Page 23 of 113 Section 3: Investment Techniques: Hedge Funds Assets and Liabilities
A. The nature of bank and mutual fund assets and liabilities
Table four: Bank assets and liabilities
Assets Liabilities Loans Deposits Capital
A banks balance sheet is straightforward: its assets are loans to customers and its liabilities are a combination of deposits and capital. Regulatory complexity arises from the fixed nature of the liabilities - a bank must return, almost always on demand, the full amount of any deposit. Table five : Open ended mutual fund assets and liabilities Assets Liabilities Assets Shareholders equity Redemptions An open ended mutual fund assets consist of securities and other investments: it liabilities consist of shareholder funds and the duty to redeem (at some formula related to net asset value) any shares tendered by shareholders within time limits specified by agreement or Anthony Hanlon Page 24 of 113 statutory provision. Roe 30 drew the following distinction between mutual funds and banks: Unlike banks, mutual funds are not highly leveraged. A decline in value at a large undiversified mutual fund does not have the same risks as a decline in value of a highly leveraged bank. The decline in value at the mutual fund is absorbed by thousands of unlucky individuals; the absorption is smooth, the transaction costs low. The decline in value at a highly leveraged bank is absorbed by bank stockholders and the government insurance fund; the absorption of losses is bumpy, transaction costs are high, the moral hazard of excess risk-taking by insolvent banks is substantial. B. The nature of hedge fund assets and liabilities
Table six : Hedge fund assets and liabilities
"Long" positions Borrowed stock "Contingent" liabilities Borrowed cash "Contingent" assets Capital
Conventional mutual funds assume risk by investing shareholders capital in portfolios of securities. They generate profits when the assets in which they invest increase in value relative to invested capital. Hedge funds assume risk differently: by borrowing stock and 30 Mark J Roe, Political Elements in the Creation of the Mutual Fund Industry 139 U.Pa.L.Rev 1469 (1991) at 1504.
Anthony Hanlon Page 25 of 113 selling short, using borrowed funds to purchase assets or entering swap agreements. They generate profits by betting on whether security prices diverge or converge. The Basel Committee explains: [F]unds take offsetting positions in comparable financial instruments, betting on changes in their relative value. For example, a fund might take a position based on the spread of a corporate bond narrowing relative to that of a government bond of comparable maturity. The larger funds also employ such types of trading strategies across different countries and markets. Relative value funds typically attempt to hedge out exposure to movements in general market risk, but remain exposed to changes in spreads and the liquidity risk associated with the unwinding of the long and short positions of a trade 31 . Unlike conventional mutual funds, the impact of any decline in asset values in a hedge fund is not confined to a dispersed group of shareholders: any decline directly impacts the limited number of institutions who act as counterparties in these transactions. Detailed examination of each type of transaction demonstrates the risks bourn both by the counterparties and the hedge fund itself. 1) Borrowed cash A hedge funds borrows cash and uses the proceeds to purchase securities. In so doing, it resembles a bank. 32 The hedge fund bets that its assets will appreciate while its borrowing costs either remain fixed or decline (e.g. because it borrowed in a currency which the hedge fund manager expects to decline). The Basel Committee noted: 31 The Basel Report page 9 32 But its assets are tradable securities while bank loans constitute its liabilities. Anthony Hanlon Page 26 of 113 [M]acro or directional fundstake positions based on assumptions about the appropriate level and likely direction of fundamental economic indicators. Such funds are exposed to outright movements in market prices. 2) Borrowed securities: The Basel Committee describes this technique: Leverage can be achieved through conventional means, such as obtaining cash through unsecured or partially secured debt, but in reality much of the leverage of HLIs is created through the types of trading strategies undertaken and the transaction terms they receive from their counterparties. For example, an HLI effectively leverages its activity when it sells Treasury bonds short 33 and uses the proceeds to establish a long position in corporate bonds against the short position in Treasuries 34 , thus adding basis risk to its position. 35 Financing asset purchases by borrowing securities raises the following issues: (i) The borrower must pay to the lender any interest payments or cash or stock dividends. This requires complex record keeping and securities with high interest or dividend yields are therefore more expensive to borrow. 33 Often, large insurance and pension funds seek extra return by lending securities which would otherwise simply reside in their vaults: broker dealers have developed sophisticated businesses which match lenders
and borrowers of stock. The borrower of the security pays a fee calculated as a percentage of the current
market value of the security; this will vary depending upon supply and demand for that security.
34 The investors sells the borrowed security in the market, receives the proceeds and uses them to buy a security which the investor believes will appreciate. Thus Long Term Capital Management believed U.S.
government bonds were overvalued while corporate bonds were undervalued. It purchased corporate bonds
and financed these purchases from the proceeds of sales of borrowed U.S Treasuries which it expected to
decline in value.
35 The Basel Report page 8 Anthony Hanlon Page 27 of 113 (ii) The borrower may give, as collateral, to the lender any security purchased with the proceeds of borrowed stock. This gives the appearance of safe lending. The Basel Committee observed: In the case of LTCM and other HLIs, OTC contracts were conducted primarily on a collateralised basis. Counterparty measurements of current replacement value, net of collateral, generally resulted in minimal exposures. However, as is discussed in more detail below, such a measure of exposure does not capture the potential costs associated with liquidating/replacing positions under adverse market conditions and possible legal obstacles to the liquidation of collateral posted by an insolvent HLI 36 . (iii) The liability on borrowed stock is potentially unlimited: the borrower must return, not a fixed monetary value, but actual securities, regardless of whether the price rises tenfold or a hundredfold. (3) Contingent assets and liabilities These fall into two categories 1. Margin: nearly all futures and option exchanges require a counterparty to make a cash deposit to offset any adverse changes in value in a futures contract. Margin is similar to the capital requirements imposed by regulators on broker dealers and is designed to ensure that, in the event a trading position must be liquidated, the amount of collateral plus margin exceeds any exposure to the party in default. In the OTC swaps market and the securities borrowing market, the amount of margin payment required is set by negotiation between market participants. The practical limitation on the amount of risk a hedge fund can assume is the amount of capital it posses to make margin payments. For example if a fund has $100m in capital 36 Basel Report Page 12 Anthony Hanlon Page 28 of 113 and posts margin equal to 10% of the notional amount of every swap agreements or the market value of securities it borrows it can assume risk of $1,000m. If its capital falls to $50m, it can only assume risk of $500m. To offset such a decline in capital would require the purchase and sale of $500m of securities. If margin requirement rose to 20% the effect would be the same. 2. Swap contracts: a swap contract is a contract between two parties where each agrees to pay the other an amount of cash, based on changes in the price of other securities or interest rates or currency levels. Without having to invest capital buying or borrowing securities, the fund becomes exposed to any changes in these securities. What it receives or pays will vary over time, contingent on the price changes which occur. The offshore euro and OTC derivative markets are dominated by the large international banks and brokerage houses. Their extensive role as a counterparty in these markets provides a direct link between the performance of hedge funds and the general banking system. (4) The Prime Broker Borrowing securities and financing intra-day margin changes is complex. To overcome these administrative and financing problems, most hedge funds appoint a prime broker. The Working Group described the role of the prime broker in the following terms: Like most hedge funds, LTCM centralized much of its custodial, recordkeeping, clearance, and financing services with a single firm. This bundle of services is typically referred to as prime brokerage and generally includes the following: providing intraday credit to facilitate foreign exchange payments and securities Anthony Hanlon Page 29 of 113 transactions; providing margin credit to finance purchases of equity securities; and borrowing securities from investment fund managers on behalf of hedge funds to support the hedge funds short positions (thus allowing investment funds to avoid direct exposure to hedge funds) 37 . (5) Discussion 1. These techniques allow hedge funds to become very large in terms of notional risk; the sole limitation is having adequate cash to finance margin payments. The Basel Committee observed: Clearly, one of the most noteworthy aspects of the LTCM case relates to the size of its positions, especially taking into account its off-balance-sheet exposures. LTCM is reported to have had a very large number of trades on its books with total assets of $125 billion. Notional off-balance-sheet positions amounted to well over $1 trillion, consisting primarily of futures contracts on various exchanges, interest rate swaps and various other types of OTC derivatives positions (although many of the contracts were in fact offsetting) 38 . The activities and techniques of hedge funds are very similar to the trading activities of broker dealers. The GOA 39 discussed the difference: Although several large securities and futures firms had leverage ratios comparable to LTCMs, according to SEC, the assets carried by the securities firms were less volatile. In addition, the Presidents Working Group report noted that these firms may be in 37 The Working Group Report page 17 38 The Basel Report at page 10 39 The GOA Report at page 6 Anthony Hanlon Page 30 of 113 a better position to ride out market volatility because they tend to have more diversified revenue and funding sources than hedge funds. These benefits, however, tend to be offset by securities and futures firms more constricted costs structures, higher fixed operating expenses, and illiquid assets. Table seven Comparison with securities houses 40 In 1996 LTCM had accumulated capital close to $7 billion, almost as much as Merrill Lynch 41 . The private trading exemption nonetheless allowed LTCM to avoid both the disclosure and capital requirements to which Merrill Lynch and other broker dealers were subject. Most of the large broker dealers are either public corporations or part of public corporations (e.g. Salomon Smith Barney), with traders reporting to management teams who are accountable to shareholders or parent companies. LTCM employed 100 people with the management group consisting of its key traders. The private trading exemption created a concentration of financial power in the hands of a very small group accountable largely to themselves 42 . 40 The GOA Report at page 7 41 Roger Lowenstein, When Genius Failed: the Rise and Fall of Long Term Capital Management, Random House, 2000 at 113 42 Id at 49 Anthony Hanlon Page 31 of 113 2. Conventional accounting methods give inadequate guidance to the potential risks: IOSCO noted; In general, leverage can be measured in a number of ways. The traditional measure is "balance sheet leverage", i.e., the ratio of the HLIs balance sheet assets to equity. Balance sheet leverage has several weaknesses, however, including a failure to take into account market, credit, and liquidity risks in a portfolio, as well as the use of off-balance sheet products such as derivatives. "Economic leverage", is a measure of the degree of risk taken on by the HLI in relation to its ability to bear that risk, i.e., the ratio of potential gains and losses to net worth. While this may produce a more meaningful measure of leverage in terms of risk, the measurement of leverage on this basis is far from straightforward. Because these measures of leverage each have strengths and weaknesses, both of them may be of use in assessing whether or not an entity is an HLI. Any measure of leverage should address the off-balance sheet relationship of market and credit risks. 43 The Basel Committee concurred: In addition to sheer size, LTCM appears to have been highly leveraged. LTCM had an equity/balance-sheet asset ratio of about 25 to 1 at the beginning of 1998. This is of course only a very incomplete measure of leverage since it does not account for the impact of LTCMs derivatives portfolio. It is not clear how large LTCMs true leverage was, based on a more meaningful measure that relates capital to some comparable measure of risk for the whole portfolio. 44 43 The IOSCO Report at 11. 44 The Basel Report at page 10. Anthony Hanlon Page 32 of 113 Cash flows under swap agreements are unpredictable and may change from positive to negative several times over the life of the agreement. This precludes standard cash flow discounting. Some institutions use risk models to calculate the likely cash flows and then apply NPV calculations. Others attempt to forecast how changes in key financial variables impact the projected cash flows the Value at Risk Methodology 45 . The collapse of Enron and the criticisms of the GAAP treatment of off balance sheet exposure demonstrate this is not a problem confined to hedge funds 3. The absolute amount of money made from these transactions is low. Lowenstein 46 noted of LTCM: This return on total capital [for 1995] was approximately 2.45%. This miniscule figure is what Long Term would have earned had it invested only its own money. But even this figure is too high because it doesnt reflect Long Terms derivative tradesTaking its derivative trades into account, its cash on cash return [in 1995] was less than 1%. The exact number is unimportant. The point is that almost all its heady 59% return was due toleverage. The implication is that if small changes in two security prices can generate high returns, small changes in the wrong direction can wipe out capital. 4. Hedge fund investment techniques create a nexus between otherwise distinct securities or securities markets. This is particularly true where a hedge fund reverses a position i.e when it has purchased one security (or market) and financed it by shorting another. LTCM purchased emerging market debt, financed by borrowing treasuries. When it attempted to close that position, it sold its emerging market bonds, depressing prices. Thus an increase in the price of treasuries had an impact on an otherwise unrelated markets. The use of leverage magnifies these effects. 45 For a general discussion of these techniques see Michael E.S. Frankel, Derivatives and Risk: Challenges Facing the Investment Management Industry, at 333 of Kirsch, The Financial Services Revolution, chapter
15, Irwin Professional Publishing 1997
46 Lowenstein supra at 78 Anthony Hanlon Page 33 of 113 C. Long Term Capital Management The story of Long Term Capital Management is well documented, both in the press, and in the subsequent government reports. 47 In brief, its principals had developed complex mathematical models for predicting the relative price of different securities. Throughout 1998, the model indicated that US Treasuries were overvalued relative to other bonds, particularly corporate bonds. The model also indicated that share prices had fallen by abnormal amounts. LTCM used all the techniques discussed above: in particular, it sold short treasuries and bought corporate bonds, posting the corporate bonds as collateral. LTCM also entered swap agreements in which LTCM received premiums in return for guaranteeing to pay the difference between the current price and any future price of shares and share indices 48 . LTCM believed share prices would not fall further and LTCM would simply pocket the premium. When Russia defaulted on its bonds, investors bought even more treasuries, widening the price gap with corporate bonds to levels LTCMs model had never predicted. Similarly share prices fell further. LTCMs prime broker, lenders and swap counterparties demanded cash as margin payment to offset the difference. But LTCMs positions were so big it could not close out positions to raise cash without pushing prices lower, thus aggravating its problems. In September 1998, LTCM simply ran out of cash to make margin payments. Table eight LTCM losses by category from January 1 st 1998 to September 30 th 1998 49 Russia and other emerging markets $430m Directional trades in developed countries
The web site itself may have changed. You can check the current page or check for previous versions at the Internet Archive. Yahoo! is not affiliated with the authors of this page or responsible for its content. Harvard Law School Proposals for Reform of Hedge Fund Regulation Submitted to Professor H. Scott Harvard Law School Proposals for Reform of Hedge Fund Regulation
Submitted to Professor H. Scott in fulfillment of the LLM Written Work Requirement
By Anthony P. Hanlon
Cambridge, Massachusetts April 24, 2002 Anthony Hanlon Page 3 of 113 Contents Section Page Summary 5 One: Definitions 7 A. Hedge Funds: In Theory 7 B. Hedge Funds: In Practice 11 C. Conclusion 13 Two: The Market 14 A. Overview 14 B. Buyers of Hedge Funds 15 C. Providers of Hedge Funds 19 D. Conclusion 21 Three: Investment Techniques 23 A. The Nature of Bank and Mutual Fund Assets and Liabilities 23 B. The Nature of Hedge Fund Assets and Liabilities 24 C. Long Term Capital Management 33 D. Conclusion 34 Four: The Position of Hedge Funds in the US Regulatory Framework 35 A. The Objectives of Securities Regulation 35 B. Exemptions from Regulation 37 C. Public Fund Regulation and Hedge Funds 41 D. Conclusion on Investor Protection Issues 61 E. Market Efficiency, Transparency and Fairness 64 F. Conclusion 67 Anthony Hanlon Page 4 of 113 Contents (continued) Five: Policy Issues Raised by the Regulatory Status of Hedge Funds 68 A. Definition of Systemic Risk 68 B. Review of Issues Raised By the LTCM Crisis 69 C. Discussion 84 D. Policy Responses In the Wake of the LTCM Crisis 91 E. Discussion 99 F. Conclusion 101 Six: Recommendations 102 A. Characteristics of the party subject to a disclosure obligations 102 B. Who meets these criteria? 102 C. What information must be provided, to whom and how often? 108 D. Conclusion 111 Bibliography 113 Anthony Hanlon Page 5 of 113 Summary Hedge funds are unregulated, offshore mutual funds, owned by sophisticated investors and subject to limited disclosure requirements. They use their deregulated status to concentrate risk and utilize leverage to magnify risk. Formerly, hedge fund investing was limited to a handful of wealthy individuals: but US financial institutions now allocate a growing percentage of their assets to investments in hedge funds. This has fuelled strong growth in capital invested in hedge funds, which now amounts to approximately $600bn; using conservative assumptions, total capital could reach $1 trillion within two or three years. The widespread use of short selling techniques and over the counter derivatives allow hedge funds to assume levels of risk and to adopt positions in financial markets which can be measured in multiples of their base capital. But these techniques result in balance sheets as highly leveraged and vulnerable to shocks as those of banks. US federal securities regulation draws a distinction between investment funds sold to sophisticated investors and those sold to the public. Private investment funds are largely exempt from federal regulation and most hedge funds adopt this format. Public investments funds are subject to detailed regulation and oversight. This paper argues only two of the public fund regulations are inconsistent with hedge fund investment techniques those concerning diversification and leverage. These provisions were designed to address issues which were important in the 1930s, but are largely irrelevant today. The collapse of Long Term Capital Management in September 1998 highlighted that hedge fund secrecy is a potential source of systemic risk. The Presidents Working Group on Financial Markets has proposed that hedge funds provide better information to their transaction counterparties. This policy does not address the core problem and has potentially damaging side effects: instead, public disclosure of information on individual funds is required. Anthony Hanlon Page 6 of 113 US public fund regulation should adjust to encourage hedge funds to operate within the framework of the Investment Company Act of 1940. In addition, disclosure obligations about individual hedge funds should be imposed on the prime broker: the prime broker should disclose for each fund (1) the aggregate notional positions by market and (2) measures of solvency. This data should be disclosed monthly with an exemption for all hedge funds with total positions under $100m. Anthony Hanlon Page 7 of 113 Section 1: Definition A. Hedge Funds: In Theory Hedge fund is a loosely used term. No statutory or judicial definition exists. Given, the emphasis of US securities law on limiting what securities may be offered to the public, the Presidents Working Group on Financial Markets 1 (the Working Group) started its examination by analyzing hedge fund investors:
Although it is not statutorily defined, the term [hedge fund] encompasses any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public. The primary investors in hedge funds are wealthy individuals and institutional investors. In addition, hedge fund managers frequently have a stake in the funds they manage. 2 . The General Accounting Office 3 reflected the approach of the Working Group: it chose to highlight what position hedge funds occupied in the regulatory structure of the United States. Hedge fund, though not legally defined, is the term used to loosely refer to an investment fund structured to be exempt from certain investor protection requirements and thus able to follow a flexible investment strategy. Hedge funds, which are often exempt from the Investment Company Act and some (but not all) reporting 1 Hedge Funds, Leverage and the Lessons of Long Term Capital Management Report of the Presidents Working Group on Financial Markets, April 1999 hereinafter The Working
Group Report Available at http://www.ustreas.gov/press/releases/docs/hedgfund.pdf 2 The Working Group Report at page 1. 3 Long Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk, United States General Accounting Office, October 1999 hereinafter The GOA Report. Available at http://www.gao.gov/archive/2000/gg00003.pdf Anthony Hanlon Page 8 of 113 requirements under the Commodities Exchange Act, are different from registered investment vehicles, such as mutual funds, in several important ways. Hedge fund managers are able to (1) invest in any type of asset in any market, (2) use many investment strategies at the same time, (3) switch investment strategies quickly, and (4) borrow money and/or otherwise use leverage without being subject to investment company leverage limits. Compared to commercial banks, which had about four times as many assets, and mutual funds, which had five times as many, hedge funds are relatively small 4 . The Working Group also commented upon investment techniques: [hedge funds] are able to sell securities short and to buy securities on leverage. While this activity is not unique to hedge funds, hedge funds often use leverage aggressively Hedge funds are also diverse in their use of different types of financial instruments. Many hedge funds trade equity or fixed income securities, taking either long or short positions, or sometimes both simultaneously 5 . The Bank of International Settlements 6 (The Basel Committee) focused upon those characteristics affecting the interaction between hedge funds and banks. These included lack of regulatory oversight, limited disclosure and the use of leverage. It adopted the term Highly Leveraged Institution (HLI) : 4 The GOA Report at page 38 5 The Working Group Report at page 2 6 Banks Interactions with Highly Leveraged Institutions, Basle Committee on Banking Supervision January 1999 hereinafter the Basel Report
Available at http://www.bis.org/publ/bcbs45.pdf
Anthony Hanlon Page 9 of 113 It is difficult to provide a precise definition of a highly leveraged institution. For the purpose of this paper, the focus is on those types of large financial institutions that generally have a combination of the following attributes First, they are subject to very little or no direct regulatory oversight.Second, the HLIs considered in this paper are generally subject to very limited disclosure requirementsThird, such institutions often take on significant leverage, where leverage is the ratio between risk, expressed in some common denominator, and capital 7 . The Basel Committee also commented on trading strategies: much of the leverage of HLIs is created through the types of trading strategies undertaken and the transaction terms they receive from their counterparties. 8 The International Organization of Securities Commissions 9 (IOSCO) broadly accepted the definition used by the Basel Committee; but chose to highlight trading activities and the adoption of offshore jurisdictions. HLIs are, for the purposes of this paper, institutions which are significant traders for their own account in financial instruments and which display a combination of the following characteristics : (i) they take on significant leverage; (i) they are subject to little or no direct prudential regulation; (ii) they are subject to limited disclosure requirements as they are seldom public companies. 7 The Basel Report at page 8 8 The Basel Report at page 8 9 Hedge Funds and Other Highly Leveraged Institutions, International Organization of Securities Commissions hereinafter The IOSCO Report. Available at http://www.iosco.org/docs-public/1999- hedge_funds.html Anthony Hanlon Page 10 of 113 (iii) They are often organised in or operate from or through offshore jurisdictions that may be regulatory or tax havens 10 . IOSCO later states: The combination of size, leverage and ability to take very concentrated positions means that the trading activities of certain HLIs may have an effect on markets, even under normal market conditions 11 . Investment industry participants tend to distinguishing hedge funds from other forms of investments by emphasizing their high risk investment strategies. Ervin 12 makes the following observation about hedge funds: In fact, hedging is neither the purpose nor the nor the normal practice of hedge funds, which are more aptly characterized as speculative trading vehicles that take positions designed not to offset risk created by existing investments but to assume calculated risk in pursuit of above average gains. Lavinio 13 also emphasizes the broad range of investment tactics used by hedge funds: [Hedge Funds] stated objective is to generate above average returns for their investorsbecause their mandates are not restricted to plain buy and hold commodity, equity and fixed income investments, hedge funds are often called alternative investment vehicles Because they are not restricted to buy and hold investment strategies, most hedge funds seek to generate their returns by using some or all of the following techniques: short 10 The IOSCO Report at 5 and 6 11 The IOSCO Report at 16 12 Hedge Funds in the 1990s published in Kirsch, The Financial Services Revolution, chapter 16, Irwin Professional Publishing 1997 13 Lavinio , The Hedge Fund Handbook McGraw-Hill 2000. Pages 1-3 Anthony Hanlon Page 11 of 113 sellinghedgingarbitrageleveragingsynthetic positions or derivatives. in exchange for lower or no regulation, such vehicles tend to be restricted to sophisticated and/or wealthy investorsand for this reason tend to have high minimum investment levels. 14 Crerend observes: However expansive the term, hedge fund investing remains essentially the same. That is, you are long something because you believe the price will rise and short something because you believe the price will decline, and if you are really certain, you will borrow money to do either or both 15 The Economist 16 elaborated [O]ne of the few common characteristics of hedge funds is their aristocratic focus on absolute returns: the notion you can make money even if there is a bear market in stocks or bonds. B. Hedge Funds in Practice Van Hedge Funds Associates 17 , a private sector hedge fund database summarized the characteristics of the average hedge see table one. It highlights : 1. Hedge funds are small: the median fund size is only $22m 2. Hedge funds have limited track records: the median fund age is 5.3 years. 3. Hedge fund managers have extensive industry experience - 15 years on average. 14 Lavinio, supra, at page 157 15 Crerend Fundamentals of Hedge Fund Investment McGraw Hill 1998, page 1. 16 The Economist, Spetember 1 st -7 th 2001, page 60: Measuring hedge funds: the benchmarking bane 17 Available at http://www.vanhedge.com/index.htm Anthony Hanlon Page 12 of 113 4. Hedge fund management fees are high: the median is 1% of assets under management plus 20% of any gains relative to a stated objective (often termed a high water mark). Table One Global Hedge Fund Characteristics As at 4Q1999 Mean Median Mode Fund size $87m $22m $10m Fund age 5.9 years 5.3 years 5.0 years Minimum investment required $695,000 $250,000 $250,000 Number of entry dates 34 12 12 Number of exit dates 28 4 4 Management fee 1.70% 1.00% 1.00% Performance allocation ("fee") 15.90% 20.00% 20.00% Manager's Experience: In securities industry 17 years 15 years 10 years In portfolio management 11 years 10 years 10 years Yes Manager is a US registered investment advisor? 45% Fund has hurdle rate 17% Fund has high water mark 75% Fund has audited financial statements or audited perf 98% Manager has $500,000 of own money in fund 75% Fund is diversified 57% Fund can short sell 84% Fund can use leverage 72% Fund uses derivatives for hedging only, or none 72% Source: VAN hedge Fund Advisors International Anthony Hanlon Page 13 of 113 C. Conclusion Summarizing these characteristics, it is possible to adopt identify hedge funds as investment schemes which: 1. Are utilized by sophisticated investors. 2. Pursue risk through (i) concentrated portfolios (ii) strategies derived from complex mathematical models (iii) intensive short term trading activity (iv) extensive use of derivatives 3. Use of leverage to magnify risk. 4. Make limited disclosure to market participants and regulators. 5. Adopt legal residence in offshore jurisdictions. Hedge funds form part of the unregulated financial markets to which the euro-deposits, eurobonds and over the counter derivatives (swaps) markets belong. This raises three questions: (1) is the unregulated mutual fund market as important as the other unregulated financial markets: (2) why do hedge funds seek unregulated status and (3) what policy issues arise from the unregulated status of hedge funds? Section two examines the size of the hedge fund market and section three discusses what implications arise from the growing amount of capital at their disposal. Section four reviews the position occupied by hedge funds under U.S. regulations to discuss why they seek unregulated status. Section five discusses what policy issues arise from current regulatory status of hedge funds. Section six sets out proposals for reform.
Anthony Hanlon Page 14 of 113 Section Two The Market for Hedge Funds A. Overview In September 2001, the Economist 18 published an article headed Hedge funds: The Latest Bubble? It noted that in the first half of 2001, almost twice as much money flowed into hedge funds as in the whole of 2000. Chart One: The Size of the Hedge Fund Market 19 Growth of Assets and Number of Funds 0 100 200 300 400 500 600 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year 0 1000 2000 3000 4000 5000 6000 7000 No. of Funds $ under management (bn) No of funds Chart one illustrates the rapid growth of hedge funds in recent years. The LTCM fiasco notwithstanding, hedge funds assets grew rapidly in 2000. Forecasting the size of the market is a function of three variables:
18 The Economist, September 1 st -7 th 2001, Page 59, Hedge Funds, The Latest Bubble? 19 Source: Van Hedge Fund Associates, available at http://www.vanhedge.com/index.htm Anthony Hanlon Page 15 of 113 (1) Determining who future buyers of hedge funds might be (2) Estimating the value assets these buyers have available for investment (3) Estimating what percentage of these assets might be allocated to hedge funds. Obtaining accurate data on hedge funds when no central source exists is difficult: the following overview of the market is obtained from a survey conducted in March 2001. In addition to published sources, extensive interviews were carried out with prime brokers in the US and the UK, and professional advisers to hedge funds accountants and lawyers. B. Buyers of Hedge Funds Chart Two summarizes the current ownership of hedge funds: ownership is divided between wealthy individuals (High Net Worth Individuals or HNWI) and institutions. At present there is no mass retail market. Chart Two Current Structure of Hedge Fund Market US Insurance 1% US pensions 4% US HNWI 42% US non- profit 18% Europe insurance 1% Europe pensions 0% Europe HNWI 34% Source: Van Hedge Fund Advisors, 1999 Anthony Hanlon Page 16 of 113 (1) HNWI Wealthy individuals (High Net Worth Individuals or HNWI) individuals with assets in excess of US$ 1 million - account for over 60% of the approximately $600bn invested in hedge funds. There are signs that hedge funds are becoming a standard element in HNWI not just super wealthy portfolios. In Switzerland, anecdotal evidence suggests private banks now recommend investing up to 30% of assets in alternative investments. And in the UK, a leading wealth manager recently announced it was recommending up to 25% of client assets in alternative investments. In the US, advisors recommend anywhere from 10-40%. (2) Institutions Table two: asset allocation amongst leading US university endowments Institution Domestic Equity International
Equity Hedge/
Arbitrage Private
Equity Fixed
Income Real
Estate Cash Brown 25 19 18 9 20 4 5 Colgate 37 11 14 7 23 3 5 Columbia 25 12 18 22 9 6 8 Cornell 42 10 16 5 23 3 1 Dartmouth 35 15 7 18 14 7 4 Davidson 43 12 3 11 20 9 2 Duke 15 14 25 28 12 6 0 Furman 34 20 9 7 19 8 3 Harvard 22 22 10 16 16 8 6 Princeton 16 15 24 22 12 8 3 Stanford 27 22 9 15 9 18 0 Vanderbilt 39 19 11 15 11 5 0 Virginia 12 8 25 26 12 9 5 Wake Forest 54 12 4 5 19 4 2 Yale 15 11 21 29 10 13 1 Average 29 15 14 16 15 7 3 U of R
Current Policy 30% 15% 20% 30% 0% 5% 0% Anthony Hanlon Page 17 of 113 Source: Data provided by a leading US foundation with extensive hedge fund investments, derived from survey of similar foundations. Institutions are under-represented amongst investors in hedge funds but now seem to view alternative investments both private equity and hedge funds as a necessary part of portfolio management 20 . A survey by Goldman Sachs and Frank Russell 21 suggests that the average US plan sponsor anticipates their strategic allocation to alternative investments will rise to 8% over the next three years. Demand can be simply estimated by multiplying the total assets held by institutions by target percentage weighting. Table three: Potential for US institutional investment in hedge funds 22 Total assets in 2000 in $ billion Amount available for hedge fund investments assuming 8% allocation Pension plans $7,674 $614 Insurance Companies $4,000 $320 Mutual Funds $6,200 $496 Total $17,874 $1,430 The adoption of these investment targets by US institutions could produce demand equal to $1,430bn. While investment in hedge funds on this scale is extremely unlikely in the near term, this analysis indicates the potential. European institutions have much lower weightings to alternative investments than US counterparts and the rate of take up does appear to be much slower. But even modest changes in policy 20 Watson Wyatt / INDOCAM - Alternative investment review relating to the continental European marketplace, 2000 and Watson Wyatt / INDOCAM - Alternative investment review relating to the North
American marketplace, 2000 21 Cited in the Indocam survey, supra 22 Source: Jackson, Regulation of Financial Institutions chapter 3, page 9 Anthony Hanlon Page 18 of 113 could increase demand amongst European institutions from the current US$8bn to US$40-50bn. The hedge fund industry currently lacks the key building blocks needed to develop an institutional product education of clients, distribution, institutional marketing, transparency around process and valuations, large scale manufacturing capacity, among managers and sophisticated after-sales service 23 . But the investment management industry is full of precedents - equity fund management, international fund management, emerging markets fund management where it has rapidly addressed these deficits. The rate of growth in the institutional sector hinges on the ability of the industry (1) to build an effective distribution mechanism which educates clients and (2) to build an effective platform capable of managing hedge fund assets on the scale required by institutions. The precise rate of take up incorporated into any forecast hinges on the speed at which the investment management industry delivers these solutions. (3) Mass retail market Hedge funds limited to sophisticated investors - are not available to the general public. Attempts by the industry to launch them have tended to meet effective resistance from regulators. The unregulated nature of hedge funds precludes the development of a mass retail market along the lines of the mutual fund industry. Regulators show little signs of softening their attitude. (4) Summary Demand for hedge funds could grow from $600bn to $1,000bn over the next two or three years under fairly undemanding assumptions i.e that HWNI invest at the same rate and that US institutions invest no more than 2.5% of assets in hedge funds and European institutions increase exposure to $50bn. The fastest growing segments are likely to be be: 23 Indocam survey, supra Anthony Hanlon Page 19 of 113 1. The mid level HNWI market in the UK and the USA. 2. Pension plans in the USA. 3. Institutions in the UK, Switzerland, Sweden and the Netherlands
C. Providers of Hedge Funds
Lack of production capacity is the dominant characteristic of the hedge fund industry. This makes itself felt in several ways; 1. Very high fees and very high profitability. The typical hedge fund manager charges a management fee in excess of 1% 24 (versus 40-50 bp on the typical long only portfolio) and usually is entitled to 20% of the profit if a certain target return is exceeded. 2. There are few large scale producers: the largest hedge fund is has US$16bn under management 25 . This compares with the largest pension fund or mutual fund producers who can manage assets exceeding US$100bn. One reason for this is that many hedge fund managers do not believe their techniques could work with large assets under management. They close their funds to new funding once they reach a certain size. Lack of capacity may represent a major break on the growth of the hedge fund industry. 3. The industry is very skewed. The market leaders - about 20 hedge fund groups - have assets in excess of $500m. This implies a very long tail of small funds Van Hedge Fund estimate the average hedge fund is only US$ 25m in size but the high fees and very low costs make operations on a small scale viable. 24 see Table One, supra. 25 Van Hedge Funds database, supra. Anthony Hanlon Page 20 of 113 Chart Three Location of Hedge Fund Managers by Assets 81% 15% 4% USA Europe Other Source: FT, 9 Feb 2001 / Goldman Sachs 4. The vast majority of hedge fund managers are located in North America largely in the New York and Los Angeles areas. But in Europe London particularly- a large number of companies are starting up. Anecdotal evidence suggests US managers are opening in larger scale in London. 5. All legal and accountancy representatives reported that established investment adviser complexes were establishing hedge fund capabilities. Reasons cited for doing so include retaining key staff as well as developing new, high margin business. This may represent an important factor driving growth; many fund management complexes, facing competition from index funds 26 are looking for new, higher margin businesses. 6. The provision of support services covering prime brokerage, custody and fund administration are well established by third party suppliers. The areas where service provision remains very poor is in fund raising, risk management and regulatory compliance. 26 Portfolios which attempt to replicate the performance of market indices such as the Standard and Poors 500 Index. Anthony Hanlon Page 21 of 113 7. Most advisors noted a specific life cycle for hedge funds. New start ups, to be viable, had to raise about $20m. If performance is good the fund re- opens 12 months later and grows to $60-100m. If performance is sustained, a further 12 months on, the fund can re-open and grow to $300-600m. But in practice few funds grow beyond the $25-30m size. 8. The credibility of the investment decision making process is critical to fund- raising. The investment managers must have considerable experience and those with good reputations can raise $250m at launch. Experience in short selling is critical as are robust risk control measures. There are signs that with the amount of institutional money facing the market, standards and expectations on managers are falling. D. Conclusion
The Economist 27 made the following observations: Some people reckon the industry is coming of age: it is growing more sophisticated as it acquires a track record that looks more appalling to investors each time that other asset classes - from shares to venture capital suffer yet another fall. And for all the rapid growth in hedge funds, the scope for more remains. Only one in five high net worth individuals now invests in any form of private equity (which includes venture capital as well as hedge funds)Others are more skeptical.The party poopers are led by Barton Biggs of Morgan Stanley, a veteran investment strategist and bubble spotter. The hedge fund mania in both America and Europe, bears all the signs of a classic bubble. 27 The Economist, supra Anthony Hanlon Page 22 of 113 The picture that emerges is of a large amount of potential demand being supplied by what is essentially a cottage industry. Even if capital invested in hedge funds grows more slowly than forecast - because of capacity constraints - invested capital could feasibly reach $1 trillion within two or three years. This figure is much smaller than e.g. $6-7 trillion dollars currently invested in mutual funds in the United States. It is also small compared with the $7.2 trillion outstanding in the Eurobond 28 and the $99.7 trillion notional amount outstanding in OTC swaps markets 29 The question is whether hedge funds have characteristics which magnify their significance beyond that suggested by the amount of invested capital. Section three discusses this issue. 28 Bank of International Settlements Quarterly Review, March 2002, Statistical Annex Table 11 29 The Bank of International Settlements Quarterly Review, March 2002, Statistical Annex Table 19 Anthony Hanlon Page 23 of 113 Section 3: Investment Techniques: Hedge Funds Assets and Liabilities
A. The nature of bank and mutual fund assets and liabilities
Table four: Bank assets and liabilities
Assets Liabilities Loans Deposits Capital
A banks balance sheet is straightforward: its assets are loans to customers and its liabilities are a combination of deposits and capital. Regulatory complexity arises from the fixed nature of the liabilities - a bank must return, almost always on demand, the full amount of any deposit. Table five : Open ended mutual fund assets and liabilities Assets Liabilities Assets Shareholders equity Redemptions An open ended mutual fund assets consist of securities and other investments: it liabilities consist of shareholder funds and the duty to redeem (at some formula related to net asset value) any shares tendered by shareholders within time limits specified by agreement or Anthony Hanlon Page 24 of 113 statutory provision. Roe 30 drew the following distinction between mutual funds and banks: Unlike banks, mutual funds are not highly leveraged. A decline in value at a large undiversified mutual fund does not have the same risks as a decline in value of a highly leveraged bank. The decline in value at the mutual fund is absorbed by thousands of unlucky individuals; the absorption is smooth, the transaction costs low. The decline in value at a highly leveraged bank is absorbed by bank stockholders and the government insurance fund; the absorption of losses is bumpy, transaction costs are high, the moral hazard of excess risk-taking by insolvent banks is substantial. B. The nature of hedge fund assets and liabilities
Table six : Hedge fund assets and liabilities
"Long" positions Borrowed stock "Contingent" liabilities Borrowed cash "Contingent" assets Capital
Conventional mutual funds assume risk by investing shareholders capital in portfolios of securities. They generate profits when the assets in which they invest increase in value relative to invested capital. Hedge funds assume risk differently: by borrowing stock and 30 Mark J Roe, Political Elements in the Creation of the Mutual Fund Industry 139 U.Pa.L.Rev 1469 (1991) at 1504.
Anthony Hanlon Page 25 of 113 selling short, using borrowed funds to purchase assets or entering swap agreements. They generate profits by betting on whether security prices diverge or converge. The Basel Committee explains: [F]unds take offsetting positions in comparable financial instruments, betting on changes in their relative value. For example, a fund might take a position based on the spread of a corporate bond narrowing relative to that of a government bond of comparable maturity. The larger funds also employ such types of trading strategies across different countries and markets. Relative value funds typically attempt to hedge out exposure to movements in general market risk, but remain exposed to changes in spreads and the liquidity risk associated with the unwinding of the long and short positions of a trade 31 . Unlike conventional mutual funds, the impact of any decline in asset values in a hedge fund is not confined to a dispersed group of shareholders: any decline directly impacts the limited number of institutions who act as counterparties in these transactions. Detailed examination of each type of transaction demonstrates the risks bourn both by the counterparties and the hedge fund itself. 1) Borrowed cash A hedge funds borrows cash and uses the proceeds to purchase securities. In so doing, it resembles a bank. 32 The hedge fund bets that its assets will appreciate while its borrowing costs either remain fixed or decline (e.g. because it borrowed in a currency which the hedge fund manager expects to decline). The Basel Committee noted: 31 The Basel Report page 9 32 But its assets are tradable securities while bank loans constitute its liabilities. Anthony Hanlon Page 26 of 113 [M]acro or directional fundstake positions based on assumptions about the appropriate level and likely direction of fundamental economic indicators. Such funds are exposed to outright movements in market prices. 2) Borrowed securities: The Basel Committee describes this technique: Leverage can be achieved through conventional means, such as obtaining cash through unsecured or partially secured debt, but in reality much of the leverage of HLIs is created through the types of trading strategies undertaken and the transaction terms they receive from their counterparties. For example, an HLI effectively leverages its activity when it sells Treasury bonds short 33 and uses the proceeds to establish a long position in corporate bonds against the short position in Treasuries 34 , thus adding basis risk to its position. 35 Financing asset purchases by borrowing securities raises the following issues: (i) The borrower must pay to the lender any interest payments or cash or stock dividends. This requires complex record keeping and securities with high interest or dividend yields are therefore more expensive to borrow. 33 Often, large insurance and pension funds seek extra return by lending securities which would otherwise simply reside in their vaults: broker dealers have developed sophisticated businesses which match lenders
and borrowers of stock. The borrower of the security pays a fee calculated as a percentage of the current
market value of the security; this will vary depending upon supply and demand for that security.
34 The investors sells the borrowed security in the market, receives the proceeds and uses them to buy a security which the investor believes will appreciate. Thus Long Term Capital Management believed U.S.
government bonds were overvalued while corporate bonds were undervalued. It purchased corporate bonds
and financed these purchases from the proceeds of sales of borrowed U.S Treasuries which it expected to
decline in value.
35 The Basel Report page 8 Anthony Hanlon Page 27 of 113 (ii) The borrower may give, as collateral, to the lender any security purchased with the proceeds of borrowed stock. This gives the appearance of safe lending. The Basel Committee observed: In the case of LTCM and other HLIs, OTC contracts were conducted primarily on a collateralised basis. Counterparty measurements of current replacement value, net of collateral, generally resulted in minimal exposures. However, as is discussed in more detail below, such a measure of exposure does not capture the potential costs associated with liquidating/replacing positions under adverse market conditions and possible legal obstacles to the liquidation of collateral posted by an insolvent HLI 36 . (iii) The liability on borrowed stock is potentially unlimited: the borrower must return, not a fixed monetary value, but actual securities, regardless of whether the price rises tenfold or a hundredfold. (3) Contingent assets and liabilities These fall into two categories 1. Margin: nearly all futures and option exchanges require a counterparty to make a cash deposit to offset any adverse changes in value in a futures contract. Margin is similar to the capital requirements imposed by regulators on broker dealers and is designed to ensure that, in the event a trading position must be liquidated, the amount of collateral plus margin exceeds any exposure to the party in default. In the OTC swaps market and the securities borrowing market, the amount of margin payment required is set by negotiation between market participants. The practical limitation on the amount of risk a hedge fund can assume is the amount of capital it posses to make margin payments. For example if a fund has $100m in capital 36 Basel Report Page 12 Anthony Hanlon Page 28 of 113 and posts margin equal to 10% of the notional amount of every swap agreements or the market value of securities it borrows it can assume risk of $1,000m. If its capital falls to $50m, it can only assume risk of $500m. To offset such a decline in capital would require the purchase and sale of $500m of securities. If margin requirement rose to 20% the effect would be the same. 2. Swap contracts: a swap contract is a contract between two parties where each agrees to pay the other an amount of cash, based on changes in the price of other securities or interest rates or currency levels. Without having to invest capital buying or borrowing securities, the fund becomes exposed to any changes in these securities. What it receives or pays will vary over time, contingent on the price changes which occur. The offshore euro and OTC derivative markets are dominated by the large international banks and brokerage houses. Their extensive role as a counterparty in these markets provides a direct link between the performance of hedge funds and the general banking system. (4) The Prime Broker Borrowing securities and financing intra-day margin changes is complex. To overcome these administrative and financing problems, most hedge funds appoint a prime broker. The Working Group described the role of the prime broker in the following terms: Like most hedge funds, LTCM centralized much of its custodial, recordkeeping, clearance, and financing services with a single firm. This bundle of services is typically referred to as prime brokerage and generally includes the following: providing intraday credit to facilitate foreign exchange payments and securities Anthony Hanlon Page 29 of 113 transactions; providing margin credit to finance purchases of equity securities; and borrowing securities from investment fund managers on behalf of hedge funds to support the hedge funds short positions (thus allowing investment funds to avoid direct exposure to hedge funds) 37 . (5) Discussion 1. These techniques allow hedge funds to become very large in terms of notional risk; the sole limitation is having adequate cash to finance margin payments. The Basel Committee observed: Clearly, one of the most noteworthy aspects of the LTCM case relates to the size of its positions, especially taking into account its off-balance-sheet exposures. LTCM is reported to have had a very large number of trades on its books with total assets of $125 billion. Notional off-balance-sheet positions amounted to well over $1 trillion, consisting primarily of futures contracts on various exchanges, interest rate swaps and various other types of OTC derivatives positions (although many of the contracts were in fact offsetting) 38 . The activities and techniques of hedge funds are very similar to the trading activities of broker dealers. The GOA 39 discussed the difference: Although several large securities and futures firms had leverage ratios comparable to LTCMs, according to SEC, the assets carried by the securities firms were less volatile. In addition, the Presidents Working Group report noted that these firms may be in 37 The Working Group Report page 17 38 The Basel Report at page 10 39 The GOA Report at page 6 Anthony Hanlon Page 30 of 113 a better position to ride out market volatility because they tend to have more diversified revenue and funding sources than hedge funds. These benefits, however, tend to be offset by securities and futures firms more constricted costs structures, higher fixed operating expenses, and illiquid assets. Table seven Comparison with securities houses 40 In 1996 LTCM had accumulated capital close to $7 billion, almost as much as Merrill Lynch 41 . The private trading exemption nonetheless allowed LTCM to avoid both the disclosure and capital requirements to which Merrill Lynch and other broker dealers were subject. Most of the large broker dealers are either public corporations or part of public corporations (e.g. Salomon Smith Barney), with traders reporting to management teams who are accountable to shareholders or parent companies. LTCM employed 100 people with the management group consisting of its key traders. The private trading exemption created a concentration of financial power in the hands of a very small group accountable largely to themselves 42 . 40 The GOA Report at page 7 41 Roger Lowenstein, When Genius Failed: the Rise and Fall of Long Term Capital Management, Random House, 2000 at 113 42 Id at 49 Anthony Hanlon Page 31 of 113 2. Conventional accounting methods give inadequate guidance to the potential risks: IOSCO noted; In general, leverage can be measured in a number of ways. The traditional measure is "balance sheet leverage", i.e., the ratio of the HLIs balance sheet assets to equity. Balance sheet leverage has several weaknesses, however, including a failure to take into account market, credit, and liquidity risks in a portfolio, as well as the use of off-balance sheet products such as derivatives. "Economic leverage", is a measure of the degree of risk taken on by the HLI in relation to its ability to bear that risk, i.e., the ratio of potential gains and losses to net worth. While this may produce a more meaningful measure of leverage in terms of risk, the measurement of leverage on this basis is far from straightforward. Because these measures of leverage each have strengths and weaknesses, both of them may be of use in assessing whether or not an entity is an HLI. Any measure of leverage should address the off-balance sheet relationship of market and credit risks. 43 The Basel Committee concurred: In addition to sheer size, LTCM appears to have been highly leveraged. LTCM had an equity/balance-sheet asset ratio of about 25 to 1 at the beginning of 1998. This is of course only a very incomplete measure of leverage since it does not account for the impact of LTCMs derivatives portfolio. It is not clear how large LTCMs true leverage was, based on a more meaningful measure that relates capital to some comparable measure of risk for the whole portfolio. 44 43 The IOSCO Report at 11. 44 The Basel Report at page 10. Anthony Hanlon Page 32 of 113 Cash flows under swap agreements are unpredictable and may change from positive to negative several times over the life of the agreement. This precludes standard cash flow discounting. Some institutions use risk models to calculate the likely cash flows and then apply NPV calculations. Others attempt to forecast how changes in key financial variables impact the projected cash flows the Value at Risk Methodology 45 . The collapse of Enron and the criticisms of the GAAP treatment of off balance sheet exposure demonstrate this is not a problem confined to hedge funds 3. The absolute amount of money made from these transactions is low. Lowenstein 46 noted of LTCM: This return on total capital [for 1995] was approximately 2.45%. This miniscule figure is what Long Term would have earned had it invested only its own money. But even this figure is too high because it doesnt reflect Long Terms derivative tradesTaking its derivative trades into account, its cash on cash return [in 1995] was less than 1%. The exact number is unimportant. The point is that almost all its heady 59% return was due toleverage. The implication is that if small changes in two security prices can generate high returns, small changes in the wrong direction can wipe out capital. 4. Hedge fund investment techniques create a nexus between otherwise distinct securities or securities markets. This is particularly true where a hedge fund reverses a position i.e when it has purchased one security (or market) and financed it by shorting another. LTCM purchased emerging market debt, financed by borrowing treasuries. When it attempted to close that position, it sold its emerging market bonds, depressing prices. Thus an increase in the price of treasuries had an impact on an otherwise unrelated markets. The use of leverage magnifies these effects. 45 For a general discussion of these techniques see Michael E.S. Frankel, Derivatives and Risk: Challenges Facing the Investment Management Industry, at 333 of Kirsch, The Financial Services Revolution, chapter
15, Irwin Professional Publishing 1997
46 Lowenstein supra at 78 Anthony Hanlon Page 33 of 113 C. Long Term Capital Management The story of Long Term Capital Management is well documented, both in the press, and in the subsequent government reports. 47 In brief, its principals had developed complex mathematical models for predicting the relative price of different securities. Throughout 1998, the model indicated that US Treasuries were overvalued relative to other bonds, particularly corporate bonds. The model also indicated that share prices had fallen by abnormal amounts. LTCM used all the techniques discussed above: in particular, it sold short treasuries and bought corporate bonds, posting the corporate bonds as collateral. LTCM also entered swap agreements in which LTCM received premiums in return for guaranteeing to pay the difference between the current price and any future price of shares and share indices 48 . LTCM believed share prices would not fall further and LTCM would simply pocket the premium. When Russia defaulted on its bonds, investors bought even more treasuries, widening the price gap with corporate bonds to levels LTCMs model had never predicted. Similarly share prices fell further. LTCMs prime broker, lenders and swap counterparties demanded cash as margin payment to offset the difference. But LTCMs positions were so big it could not close out positions to raise cash without pushing prices lower, thus aggravating its problems. In September 1998, LTCM simply ran out of cash to make margin payments. Table eight LTCM losses by category from January 1 st 1998 to September 30 th 1998 49 Russia and other emerging markets $430m Directional trades in developed countries
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