Hedge funds are under the microscope like never before, as regulators and investors demand greater transparency and disclosure. What does this mean for an industry more used to operating behind a veil?

Since the start of the global financial crisis, the hedge fund industry has been the focus of heightened scrutiny. The June 2007 collapse of two hedge funds run by Bear Stearns was an early sign of trouble. Hedge funds were also one of the first groups to identify problems at Lehman Brothers and subsequently shorted the stock, an action which some believed accelerated the venerable banks descent into bankruptcy. More recently, accusations have arisen that short-term speculators (aka hedge funds) helped to accelerate Greeces debt crisis, making bets in the credit default swaps market that Greece would default on its debt.

With the rest of the European Union nervous in early March, hedge funds turned their attention and trading activities to the euro. In response to the bearish euro bets by SAC Capital Advisors, Greenlight Capital, Soros Fund Management, and Paulson & Co. the U.S. Department of Justice launched an investigation into whether the firms banded together to drive down the value of the euro.

These developments have helped to create a welcoming environment for the Hedge Fund Transparency Act, a bill to give the U.S. Securities and Exchange Commission (SEC) authority to require hedge funds and other private funds (including private equity, venture capital and real estate) to register and disclose information on their investments and investors. As Senator Charles E. Grassley, one of those who drafted the bill, pointed out: There wasnt much of an appetite for this sort of legislation before the financial crisis.

Meanwhile, this summer the EU is widely expected to adopt a law to regulate hedge funds directly, requiring fund managers to register and report an array of data to supervisors from around late 2012. Yet, according to the Financial Times, Michel Barnier, recently appointed EU internal market commissioner, conceded that the directive had been badly drafted and rushed.

Many hedge fund firms have become more transparent in a bid to win back investors.

There is a clear consensus that regulation is coming. A survey by the financial services group Rothstein Kass last year found that nearly 99% of senior hedge fund partners expect increased regulation, compared with only 8% in 2008.

What does this all mean for an industry that was already reeling from a wave of investor redemptions and fund closures due to the financial crisis? How will funds cope with the increasing obligations? Can transparency be legislated (to effectively avoid systemic risk) or will it merely bring false confidence and unanticipated negative outcomes? Can the industry take steps to repair its practices and reputation in the eyes of investors and regulators?

Potential Legislation Brings Challenges and Costs

Over its 60-year life, the hedge fund industry has seen spectacular growth. As shown in the chart below, the assets under management of the global hedge fund industry reached over $1.8 trillion at the peak of the last cycle, when pension funds, endowments, and wealthy individuals were pouring capital into these funds. While the promise of positive (absolute) returns in both up and down markets has been a key attraction for investors, so too have been the benefits of diversification, as their returns have relatively low correlation with market returns. There are more than 10,000 funds worldwide, though this number, as well as assets under management, has contracted with the global downturn.

The latest legislative proposal would require hedge funds and other private funds with more than $50 million in assets to register with the SEC and file information annually, including identifying the owners of the fund and ownership structure as well as the number of investors. The bill would also require funds to provide the SEC with the current value of the assets of their funds and assets under management. All of this information would be open and available to the public.

For hedge funds, this would mean disclosing how they arrive at the fair value of their assets. While this can be a simple process for some investments, it can be extraordinarily complex for others, particularly for less liquid investments such as credit default swaps. The legislation would also require funds to maintain a thorough and detailed process for documentation.

Complying with these twin challenges complex valuation and detailed documentation will incur considerable costs. For example, the U.S. bill, if enacted, would likely trigger an expansion in the back office support of most funds, as well as see hiring of independent third-party experts to check the multiple steps in the valuation and documentation process. There is also a technology dimension relating to the retention and organisation of vast amounts of data. Few firms will have grasped the consequences of this, let alone started to prepare for the new requirements. (See the box entitled Holding on to Your Data. )

A small number of funds have voluntarily taken many of these steps (some have registered with regulatory bodies as well), but for many firms the requirements would require significant reorganization.

The Market Response

But it is not necessarily all bad news for hedge funds. Since the onset of the financial crisis in 2008, many hedge fund firms have chosen to become more transparent, in a bid to win back investors. In that year alone, investors in hedge funds withdrew $600 billion of capital. And since the end of 2007, the number of hedge funds, and funds of funds, has declined by 20%. An April 2009 survey of limited partners, by BNY Mellon and Casey Quirk, found that transparency (along with alignment) was the top challenge facing the industry.

Coping with complex valuations will involve extra costs.

Many hedge fund managers have also been hiring independent risk assessors to oversee some of their funds activities and provide investors with detailed updates on positions, according to research by the Nexar Capital Group. The services of independent risk aggregators such as Measurisk and RiskMetrics as well as those providing third-party fund administration and managed account platforms were on the rise. Nexar reported that RiskMetrics business providing independent risk and exposure information increased by 80% over the past year.

Institutional investors who do business with hedge funds have the ability and the resources to make their demands known. Last year, the California Public Employees Retirement System (CalPERS) publicly demanded that hedge funds increase their transparency and reduce their management and performance fees. For good reason: in 2008, CalPERS saw the value of its hedge fund portfolio fall by almost 20%. The pension fund backed up its demand by withdrawing $1.1 billion from nine hedge funds that refused to follow its standards.

Hedge fund investors have also increased their due diligence requirements before committing capital, according to a Barclays Capital study released last December, and hedge fund managers have placed renewed emphasis on building relationships with investors. Moreover, investors tended to gravitate towards larger funds because these firms had the necessary infrastructure to meet investor demands for more accounting, transparency, and communication. Smaller firms, in complying with the new regulations, have an opportunity to broaden their investor base.

Funds of funds have also emerged to help smaller institutional investors choose between hedge funds. Funds of funds have grown from overseeing close to 17% of total hedge assets in 2000 to around 40% today.

Conclusion

With regulators unlikely to give up on their desire for greater transparency, disclosure and information retention, it is increasingly looking like hedge funds will have no choice other than to up their game. Whether or not new legislation and regulations are enacted, the hedge fund industry is also facing new demands for transparency from the entities who will dictate theirfuture: investors.

Those with capital to invest in hedge funds used to tolerate opacity as a trade-off for double-digit returns. But having been spooked by double-digit losses, investors now demand more information thats easier to understand and made available faster.

Holding on to your data

Over the next 12 months, hedge funds will need to examine how they handle electronic information and work out improved ways to collect it, analyze it, and reproduce it in response to regulation. The regulators will have very explicit requirements, but for most firms, the very concepts of transparency and disclosure will have far-reaching consequences.

In order to disclose information, you first need to retain it: disclosure is simply not possible without retention, and very few hedge funds currently have sufficient capabilities in this area. Large banks are used to such burdens and employ elaborate hardware and software systems and large back-office teams to ensure compliance. Hedge funds, therefore, have a lot of catching up to do and will need to invest heavily in IT systems and spend both time and money developing new protocols and processes.

First, firms need to identify the sorts of electronic information that is subject to enhanced retention and disclosure regulations. Then they need to develop the protocols and the technology for preserving the information and making it available should disclosure be required. This is not a trivial task when you are dealing with structured and unstructured data arising from multiple sources, rapidly increasing volumes of information, and you have little or no experience of doing this before. The major banks and brokers keep every communication they have with clients. But because it is not easy to separate these from the overall email, messaging or telephone system, they tend to just preserve everything. This is an extraordinary burden.

Many hedge funds employ sophisticated, often proprietary, trading platforms. Supplementing the unique architecture of these systems with backup capabilities may not be straightforward, especially in a format that will satisfy regulators. Large banks currently save information in WORM format (Write Once, Read Many), which means it cannot be altered once stored.

Hedge fund executives need to ask themselves: Do I know where all of my sources of electronic information are? Do we know how to preserve it? How are we going to analyze a million emails if a regulator asks for a specific transaction? and How will we get data relating to a certain transaction out of our trading system?

Culturally, the hedge fund world is in for a shock. Hedge funds have their roots in the trading desks, a raucous environment not renowned for being overly focused on legal compliance. While private equity funds will also be impacted by the proposed legislation in both the U.S. and Europe, private equity professionals tend to come from an investment banking background so they are more used to regulation and legal compliance.

Some private equity firms saw heightened scrutiny coming years ago and established a compliance regime that included better control of electronic information for compliance purposes. Some even voluntarily registered under the Securities Act, making them subject to the kinds of strict information retention rules that financial services firms had dealt with for many years. But the number of firms that took these steps is still very small and mostly limited to the largest and best-known ones.

The SEC and Pooled Investment Funds

FTI Hedge Fund Transparency Offer