Legal spotlight

Neil Weidner, capital markets partner, and associate Anthony Dearing at Cadwalader, Wickersham & Taft in London look at the shifting legal framework for UK hedge funds

The European landscape

To maximise tax efficiency and to minimise regulatory cost, hedge funds are in most cases located offshore and are either incorporated companies or partnerships. Broadly speaking, the operation of hedge funds is split into three parts. Firstly, the directors or trustees of the fund, who for tax reasons must normally be based offshore; secondly, fund administration and management; and thirdly, investment fund management.

In the European Union (EU), the UK is the principal centre for investment management of hedge funds. At the end of 2004, 74% of all European hedge fund assets (estimated to be in excess of EUR187 billion), were managed by UK-based investment management companies.

In relation to fund administration, Ireland is the current market leader, with a significant percentage of global assets administered in Dublin, with Luxembourg growing in popularity as an alternative.

Throughout Europe investment managers are permitted to manage most types of hedge fund as generally there is no regulatory distinction between a hedge fund manager and other types of investment manager. Such managers have, however, been subject to varying levels of regulatory supervision and requirements. In some jurisdictions, such as the UK, investment managers are required to be fully authorised and regulated.

The development of regulation covering the hedge fund industry has not been homogeneous across Europe. But creating a single market for all funds would require additional EU legislation. Without that there is a risk of regulatory arbitrage and fragmentation of the market. The European Commission has recognised that risk and has recently issued a proposal document which consults the industry and regulators on whether there are any "particular risks (from an investor protection or a market stability perspective) associated with the activities of... hedge funds". Responses to the document are due by November 15 and the Commission will issue its findings early in 2006. The Commission has also agreed to set up a working group to study whether a common regulatory approach can facilitate the further development of European markets for hedge funds.

An unlevel playing field

It is important to note that the hedge fund industry in the UK is not unregulated. Whilst UK regulator the Financial Services Authority (FSA) does not regulate hedge funds themselves or their administrators because they are invariably located offshore, it does regulate the managers that provide hedge fund services from the UK. In addition, the FSA regulates various other entities that regularly deal with hedge funds.

Since August 2002, the FSA has published several discussion papers dealing with hedge funds, culminating with Discussion Paper 05/04 (Hedge funds: A discussion of risk and regulatory engagement June 2005), which concluded that risk to market confidence and stability is unlikely to arise from a single and significant failure. Rather it is more likely to arise from the failure of a group of medium-sized hedge funds, either as a result of following similar investment strategies or because of a "contagious collapse in confidence".

The FSA has identified three principal areas where the hedge fund industry could improve, including: operational risk arising through, for example, more timely trade confirmations and notified trade assignments; better risk management through improved stress testing and more robust assessment of total risk exposure; and better asset valuation methodologies. In the absence of EU legislation specifically dealing with hedge funds, the FSA's short-term focus is likely to be twofold:

Focused supervision of investment managers

As a result of the FSA's recent Arrow project, which defined its risk-based approach to regulation, the FSA is likely to increase its prudential supervision of hedge fund managers in the UK. The FSA will only be able to do that by distinguishing hedge fund managers from other discretionary investment managers and advisers. To do this, it could create a new regulated activity but that would be a long-term undertaking and one that would only work if co-ordinated at an EU-wide level. Alternatively the FSA could simply re-categorise hedge fund managers' risk profiles.

Currently, the majority of hedge fund managers, like other discretionary fund managers, are treated as category D (low risk) firms. The current risk profile for investment managers is either weighted towards traditional discretionary fund management business, which does not take into account programme trading and high leverage, or the risk profile does not consider all asset classes or the amount of assets under management.

In practice, however, hedge fund managers typically have a different risk profile from other discretionary investment managers as a result of the investment techniques and strategies they employ. By re-categorising the risk profile of hedge fund managers, the FSA is more likely to require hedge fund managers to notify the FSA that they carry out 'hedge fund management'. That would, however, require the FSA to define 'hedge fund management', which necessarily would need to be based on a combination of investment strategy and product type rather than legal structure.

In increasing its supervision and monitoring of hedge fund managers, the FSA has two main choices: either to monitor and supervise the whole industry, or target higher-risk fund managers - those with a high risk profile, whose leverage ratios and strategies could have a significant market impact. To date the FSA has identified 15 to 25 'high impact' hedge fund managers it states could be subject to enhanced supervision.

National voluntary valuation standards

Currently, unlike for authorised funds, there is no legislative or regulatory requirement for hedge funds to be independently valued. Typically, UK-managed hedge funds tend to be valued by third-party administrators because of the often illiquid nature of hedge fund assets. Valuations are based on a combination of counterparty quotes, valuation models and valuations provided by the hedge fund managers themselves.

Whilst the FSA acknowledges that the risks here are mitigated to a certain extent by external auditors' reviews, the FSA considers that there is significant risk of conflict of interests arising. This is especially acute where the hedge fund manager provides the valuation or where the administrator is also the fund's counterparty or prime broker.

Crystal ball-gazing

It is clear that neither the European Commission nor the FSA intend to regulate hedge funds. At this stage, however, it is difficult to determine with any degree of certainty to what extent hedge fund managers in the UK will be subject to additional regulation. In the absence of changes implemented at an EU level, it is unlikely that there will be any radical changes to regulations in the UK as they currently apply.

The FSA expects to receive comments on Discussion Paper 05/04 by October 28 and anticipates issuing further comments early in 2006. So watch this space.