Hedge Fund: Corporate Counsel
Discipline, Factors, Performance
"Fraud Skews the Risk Curve"
Third in a Continuing Series
Founded more than 160 years ago, McCarter & English is the oldest, largest firm in New Jersey with 450 lawyers firm-wide and close to 60 in Connecticut, including 14 in Stamford, the epicenter of the hedge fund world. The firm serves as outside counsel to the Connecticut Hedge Fund Association (CTHFA) on a number of corporate and organizational matters, including getting a tax-exempt status based on its educational mission, according to Brunjes. Along with CTHFA, McCarter & English has sponsored seminars on pension reform and the role of short sellers in the capital markets.
By Lisa Schroder
Markets Editor
"Take calculated risks. That is quite different from being rash." - George S. Patton
A properly managed hedge fund takes measured risk, and does so by endeavoring to balance both sides of the same coin.
“People who suggest that hedge funds are fraught with unacceptably high risk, and that the people that are running them are a ‘free-wheeling bunch of cowboys’ are misinformed and preying on the lack of knowledge in the marketplace,” says John Brunjes, partner, McCarter & English, LLP.
In fact, hedge fund managers are generally heavily credentialed professionals, often with high-level Wall Street experience.
“My personal opinion is that short sellers are the ‘unacknowledged legislators’ of the marketplace,” says Brunjes. “They provide an important discipline with respect to identifying inconspicuous factors and trends in a company’s performance that often foreshadow the downside movement of the stock. That usually involves ferreting out issues that others may not be seeing, or that the company may not be highlighting, that would indicate that stock in a company might be taking a downturn.”
The unfortunate interpretation of that is that short sellers tend to be viewed as people who “profit from the down-side,” says Brunjes, “but these funds provide a valuable set of tools to the marketplace with respect to the downward trends and downward movements in stock prices.”
Does the hedge fund industry need federal regulations?
“Anytime you have so much money concentrated the way it is, people get concerned about disclosure. The marketplace gets concerned about disclosure,” says Brunjes.
He believes that the effort that’s been put forth to date by the SEC unfortunately “has just been misdirected. There are a number of less burdensome measures that could be put in place to provide meaningful information to the marketplace, both about hedge funds and the dollars that they control, as well as to protect the investing public.”
The latter concept has been missed entirely, in mind, says Brunjes.
“Exactly who is SEC purporting to protect?”
Good question.
“There are any number of preliminary steps that need to be explored before Congressional action in the form of legislation is warranted,” Brunjes maintains.
“If the greatest concern is fraud by hedge fund managers, most of the frauds that occur with respect to advisors to hedge funds tend to be in smaller funds, in the $50 million to $500 million range. If you’re concerned about fraud, and if you’re concerned about protecting the investors in those types of funds, then you either need to implement regulations specific to those funds, or you need to put in place some apparatus that captures information broadly with respect to everybody from which there is a basis for identifying potential problems before they harm investors,” he says.
“That said, fraud skews the risk curve. Nobody is going to be able to predict fraud in advance and no amount of regulation will prevent it.”
One example of a modification to the existing regulatory framework would be to raise the income and sophistication standards for eligible investors in hedge funds. An example of a new requirement that would apply broadly to all advisors to hedge funds would be to require those advisors to hedge funds to always provide audited financial statements from an independent accounting firm, Brunjes proposes.
Yet even with such a requirement, he says, investor due diligence remains paramount.
“If you examine some of the frauds that have happened over the past several years, I think you’d be surprised at the level of simplicity that has been behind some of those investor defalcations. Fabricating the accounting and auditing firms? One phone call to the State Board of Accountancy would have exposed that ploy. That shouldn’t be too hard to track down.”
Overall, requiring every advisor to a hedge fund to produce an audited financial statement should provide some level of comfort to the investors in those funds with respect to the movement of their money, the accounting for fund assets, and the valuation methodologies used in calculating the return on their money, says Brunjes. Right now, such requirements are the practice with respect to funds of hedge funds (i.e., hedge funds that invest in other hedge funds as a means of diversifying risk), but is not directly required by federal regulation.
He believes every hedge fund should be required to have an annual audit. “Investors need a level of independent certification of the cash going into and coming out of the fund, where it’s been, and how its value drives the calculation of return.”
Brunjes points out that the migration of money into hedge funds has been substantially weighted toward institutional investors over the past ten years. “What used to be more solely the province of very high-net-worth families and individuals—and still is—has become more and more the province of the institutional investor: public and private pension funds, charities and endowments, and corporations.
The pressure is on the institutional portfolio manager to achieve an increasingly high level of return, more than investing in traditional investment classes like stocks and bonds allow.
“That’s what hedge funds and other alternative classes of investments provide: the potential for significantly higher rates of return, but with increased risk.”
And then there’s the fact that the hedge fund industry has come under close scrutiny lately. Making money does tend to attract attention.
“Hedge funds generate substantial trading activity in the markets in which they operate, control substantial investor dollars (about $1.3 trillion by most estimates), and the eye-popping compensation that managers are able to earn,” he says, adding that the series of frauds that have occurred over the past three to five years have started to get the attention of regulators.
“On the other hand, the market has seen huge scandals in the mutual fund industry. This is an industry where the top 50 or so mutual funds control the same amount of total investor capital that is managed by the entire hedge fund industry, and yet these problems occurred despite volumes of laws and regulations on everything from restricting the use of leverage in trading activities, to rules on advertising and performance, to requiring broad-based disclosure to investors on virtually every facet of the mutual fund’s operations.”
But, he emphasizes, the performance track record of hedge funds over a decades-long period reveals that, despite their increased risks and performance volatility, they have generally outperformed all the other major market indices.
“A common misconception about hedge funds is that they take on unmitigated risk,” he says.
“The bottom line is hedge funds serve a valuable function in the marketplace, and if information is what the marketplace needs, then I think there are any number of ways less burdensome than increased federal regulation or legislation to get that information to investors.”
