Cayman Islands: Raising The Bar – New Standards Of Best Practice For Hedge Fund Managers?

Last Updated: 2 July 2008
Article by Paul Scrivener

Paul Scrivener of Solomon Harris takes a look at the recent reports of the UK Hedge Fund Working Group and the President's Working Group in the US.

Recent statistics indicate that the hedge fund industry is now a two trillion dollar industry. Still a small proportion of entire worldwide assets but nevertheless large enough to be on the radar screen of politicians and regulators in most of the developed world, not least in the US and the UK. For many, hedge funds are perceived as opaque and arcane and are even viewed by some as a potential threat to global financial stability, a situation which is clearly undesirable for hedge fund managers and their service providers. Therefore, recent reports out of the UK and the US with the purpose of developing best practices in the hedge fund industry, on a voluntary basis, are certainly timely. In January this year, the UK's Hedge Fund Working Group produced its Hedge Fund Standards: Final Report (the UK Report) and in April in the US the President's Working Group on Financial Markets produced reports of its Asset Manager's Committee and Investors' Committee (the US Reports). Interestingly, both the UK Report and the US Reports were the work of private sector representatives from the hedge fund industry or investors in the hedge fund industry and the approach on both sides of "the Pond" is almost identical, at least in broad terms.

These Reports are about encouraging the development of best practices within an industry which, for the most part, is lightly regulated compared to others sectors of the global financial industry and therefore an easy target for politicians and regulators whenever a scapegoat is needed. The reality is that the vast majority of hedge fund managers are both competent and professional and inappropriate regulation would only serve to stifle their ingenuity in making money for their investors. Hedge fund "blow-ups" make news and serve to fuel the popular image of hedge funds being secretive and high risk but the well-informed are fully aware that these high profile situations represent a very small minority of the hedge fund world. Nevertheless, perception is almost as important as reality and there is no doubt, whether the industry likes it or not, it must be seen to be raising the bar.

Indeed, both the UK Report and the US Reports recognise that the incredible growth of the hedge fund industry brings with it increasing responsibility and therefore it is very important for hedge fund managers to adopt comprehensive best practices across their businesses. This is clearly a laudable objective in itself but there is no doubt that the authors certainly had one eye on the need for the industry to be raising its game with a view to staving off the risk of inappropriate or unsatisfactory regulation being thrust upon it, particularly in the US and the UK.

Both sets of Reports advocate a principles-based approach to best practice rather than prescriptive rules. This is definitely desirable bearing in mind the huge diversity among hedge fund managers in terms of size and investment strategy. A "one size fits all" approach is certainly not suitable. The model in the UK Report has particular attractions in that it propounds various best practice standards (the Standards) drawn from the FSA's 11 Principles of good business conduct, with managers who become a signatory to the Standards having the option either to comply in respect of a particular Standard or explain that it is not complying and the reasons why. The UK Report makes it clear that "explaining" is not an inferior option to complying and the authors are happy to leave investor and peer pressure as the main incentive for firms to comply with the Standards. Interestingly, whilst the UK Report is very much directed towards UK based managers, most of whom are already regulated by the FSA, it welcomes and encourages overseas based managers to adopt the Standards.

The Reports on the US side, whilst still recommending broad principles of best practice, tend to sketch in a lot more detail than the UK Report, which is probably a reflection of the US preferring a more rules-based approach to good governance.

So what are the topics covered in the models advocated in both sets of Reports? The topics are reflective of the "hot" issues being discussed at any hedge funds conference these days. Most of the pages in both sets of Reports are devoted to appropriate standards in relation to disclosure to investors and counterparties, valuation, risk management, trading and business operations and conflicts of interest. In the absence of rigorous regulatory protection for investors (a model entirely unsuitable for the hedge fund industry) sufficient disclosure to enable an investor to make an informed decision about investing and continuing to invest, is essential. It is therefore no surprise that both sets of Reports have much to say on this subject not only in relation to disclosure of investment policy but also with regard to the commercial terms of the investment such as redemption rights and fee arrangements.

Much has been said and written about the valuation of hedge fund assets. This is understandable bearing in mind that valuation flows through to subscription price and redemption price as well as the manager's remuneration. Both sets of Reports emphasise the importance of robust valuation procedures and policies, segregation of responsibilities in relation to valuation and the need to manage the challenges posed by hard to value and other illiquid assets.

Standards outlined in the Reports with regard to risk management, trading and business operations and conflicts of interest are a reflection of the maturing of the industry and the need for managers to adopt an increasing level of sophistication in their business practices. The "cottage industry" approach of just a few years ago where a manager typically managed his own money and that of a few private investors, is no longer tenable in an age where an increasing number of institutional investors are making hedge fund allocations within their overall investment portfolio.

These Reports are an important and healthy contribution to the development of best practice standards within the hedge fund industry and are to be welcomed. As stated in the UK Report, these initiatives are "a first step along a road" and certainly not the end of the journey. Standards will clearly develop over time as the industry itself develops but any journey has to start with a single step. Whether that step will serve to convince the regulators of the industry's aspirations to put its own house in order, remains to be seen. We can only hope so if this vibrant and innovative industry is to continue to flourish.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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