Risk Without Reward

SEC - Hedging Your Bets

While published a while ago - back in March 2008 - we've just come across an SEC news release "Hedging Your Bets: A Heads up on Hedge Funds and Hedge Fund of Funds."

Among the SEC's words of wisdom:

- Read the offering memorandum (yep, read all the weasel words)

- Understand how a fund's assets are valued

- Ask questions about fees

- Understand redemption provisions - and restrictions on redemptions

- Research a hedge fund manager's background 

We particularly like the final comment, which is "don't be afraid to ask questions."

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Hedge Fund Operational Due Diligence

Contracts for Disclosure?

Contracts for Differences ("CFDs") have become a popular means for hedge funds to access the UK stock market.  This allows investors to buy UK stocks on margin and, secondly, avoids UK stamp duty taxation (after all, there is nothing a rational economic decision maker weighs more highly than the opportunity to avoid taxes that everyone else pays.)

The Wall Street Journal reports this morning that the UK FSA may now require new disclosure, such that investors who hold an economic interest in excess of 5% of the share capital of an investee company will have to disclose, even if that interest is held partly or wholly through CFD structures.

The reason?

"The FSA said the lack of transparency around CFDs could contribute to three potential market failures: inefficient pricing, distorted markets for takeovers and diminished market confidence."

This seems like a very good idea - if hedge funds own assets that mirror equity securities (and are priced identically to them) it is not unreasonable to see the regulators wanting to level the playing field. 

Overall, investors should always be sensitive to the use of synthetic securities - sometimes they can simply be too good to be true.  If derivative loopholes become "too popular", it seems pretty likely that, eventually at least, the regulators will act - as we have seen recently with the more heavyhanded actions in India over "P Notes".   Next on the list - perhaps total return swaps in the US designed to allow offshore investors (such as offshore hedge funds) to avoid the 30% withholding tax?  Now (for the accountants out there) that would be a good FIN 48 question.

 

California Registration

Investment News reports today on a proposal in California that all hedge funds located in the state not already registered as investment advisors with the SEC must instead register with the State. California already requires small funds to register with Sacremento - this captures firms which fall below the $25 million in assets which is the threshold for an SEC application. The new measure aims to capture funds above $25 million which have chosen to avoid registration. (SEC registration is only mandatory at the point that a hedge fund, whatever its asset base, has more than 15 clients: following the Goldstein ruling in 2006, hedge fund managers count their "clients" as the funds they run, rather than the number of end investors. This rule is like Fidelity counting its clients as the number of mutual funds it offers, rather than the number of investors in those products.)

The article leads off by claiming that this proposal could "drive much of the industry out of the state." Mr. Goldstein of Bulldog Investments (the same Mr. Goldstein who challenged the SEC's earlier registration rules) wrote in an email to the state regulator that the rule will "not go anywhere because hedge funds will threaten to move to a more friendly state, which is easy to do, and the politicians don't want to lose the tax revenue." Jack Gaine, head of the Managed Futures Association, a lobby group for hedge fund managers, states that "it is of fairly great concern that an individual state, the largest state, goes out and sets up a registration, regulatory scheme."

San Francisco has the largest concentration of managers in California, with local firms including Farallon Capital Management, one of the largest hedge fund managers in the world. A quick review of the SEC's adviser search website reveals that Farallon has been a registered advisor since April 1996 , and, per its latest ADV, has assets of some $27.6 billion.

Managers are clearly free to do whatever they want and some, no doubt, would decide to relocate if faced with the terrible and horrific prospect of state review of their books and records. From the investors' perspective, however, how should allocators react if a firm tells its clients that it has decided to relocate from San Fran to Tahoe City solely to avoid the regulators? Changing business regulations are a fact of life for millions of companies every day, and investors, in our opinion at least, should vote with their money if faced with this situation. This may be an emperor has no clothes comment, but exactly what signal do managers think they send if a firm is ready to move its entire operation to avoid regulation?