1. Definition and relevance
There is not yet a uniform, generally accepted definition of what constitutes a hedge fund. Part of the difficulty is that those participants in the financial markets typically referred to as ‘hedge funds’ constitute anything but a homogeneous group. On the contrary, they typically invest in different financial products with varying investment strategies. Etymologically, the term ‘hedge fund’ is derived from the word ‘to hedge’. It describes the initial investment strategy used by the first funds of this kind. The first hedge fund, founded in 1949 in the United States by Alfred Winslow Jones, was structured in a way to protect it from, or hedge against, general market risks. To that end, the fund bought stock it considered undervalued in the expectation of rising prices. Simultaneously, it entered into short positions on overvalued stocks. Short selling is the practice of selling assets which are not owned by the seller at the time of sale. The seller purchases the assets at a later date when he has to deliver them to the purchaser. The seller can make a profit if the price for the asset has fallen between the date of his sale and the date of the delivery to the purchaser. This strategy of holding securities and short selling others had the advantage that only events specific to the securities held or sold short by the fund would influence the value of the portfolio, but not developments affecting the whole market. Besides short selling, it is common for hedge funds to borrow money in order to purchase additional financial instruments and thereby increase their return on equity—a practice called leverage. The aim of any hedge fund is to achieve positive returns irrespective of the current economic development of capital markets.
At the end of 2006, before the start of the subsequent financial turmoil, there were over 9,000 hedge funds worldwide with an estimated combined value of about US $1,500 billion under management. Taking into account leveraging, at that time hedge funds controlled approximately 3 per cent of the worldwide assets in financial markets. However, their significance for the trade in financial instruments was and remains greater than this number implies because they account for a large part of everyday trading at the stock exchanges. The hedge fund industry reached its peak at the end of 2007 with US $2,150 billion of assets under management. Many hedge funds, however, were dissolved due to the devastating effects of the financial crisis—in 2008 alone almost 1,500 hedge funds exited the market. However, the hedge fund industry recovered quickly; the number of hedge funds went up to 9,500 again at the end of 2010 with about US $1,920 billion assets under management, and this growth is likely to continue.
Hedge funds are usually organized as limited liability companies or private limited partnerships and registered in off-shore tax havens, such as the Cayman Islands. Most hedge funds within the European Union are registered in Ireland or Luxembourg, although their offices are located mostly in New York or London.
Investment managers have significant freedom in choosing the investment strategy of their hedge funds, and the fund’s performance depends decisively on the manager’s skill and specialization. This skill and specialization is rewarded through high fees. In addition to a basic fee, there is usually a performance-related fee, often amounting to around 20 per cent of the net profits. Typically, the fund managers also invest some of their own capital in the fund. The hedge funds’ securities trading is operated by so-called prime brokers, usually investment banks. These banks play an even more important role as suppliers of debt capital (for leverage) and in providing support in the borrowing and lending of financial instruments for short sales.
2. Hedge funds and private equity funds
Hedge funds have to be distinguished from similar investment vehicles such as private equity funds. Investments in private equity funds are entrepreneurial equity investments in companies that are usually not listed on a stock exchange. Private equity funds often invest in new and expanding companies, but they also invest to restructure or take over established (even listed) companies in the context of so-called buyouts to privatize them later. This is usually accompanied by radical changes in the financial and organizational structure of the company in question. Under Anglo-American law, private equity funds are typically organized as limited partnerships, whereas in Germany they are (so-called asset managing) Kommanditgesellschaften (KG) with a Gesellschaft mit beschränkter Haftung (GmbH) as a general partner (with unlimited liability, Komplementär) and with various investors as limited partners (Kommanditisten). Investors acquire a holding in the company and thus participate in the fund’s capital. Usually, the portfolios of private equity funds are not very diversified with the number of investments being limited to about 10. Private equity funds typically have a lifespan of seven to 12 years. Shares are generally not transferable and cannot be returned to the fund before they expire. However, the differences between private equity and hedge funds are beginning to blur. Increasingly, hedge funds are attempting to exert influence on the companies they invest in. Additionally, they increasingly make long-term investments.
3. The need for regulation: advantages and risks
For investors, hedge funds promise positive returns independently of movements in the capital market as a whole. In particular, the typically low correlation of hedge fund units with other financial instruments leads to reduced risk in investment portfolios. Finally, hedge funds often have return rates of more than 30 or even 40 per cent. For entrepreneurs, hedge funds are becoming an increasingly important source of financing. Moreover, many hedge funds attempt to make ‘their’ companies more efficient by exerting influence on their financial and corporate governance. Capital markets benefit through increased liquidity and efficiency. In particular, small, illiquid markets with few transactions benefit from hedge funds’ activities. In some cases, a price formation process is possible only due to the participation of hedge funds. Finally, hedge funds offer other market participants additional possibilities of risk management, serving as their business partners and bearing their risks.
However, the activities of hedge funds also bear substantial risks. The possibility of high returns requires speculative investments with a high risk of loss of capital. The collapse of the hedge fund Long Term Capital Management (LTCM) in the United States in 1998 shifted the regulatory attention to the risks these funds pose to the stability of the financial markets as a whole. Liquidity problems of a large hedge fund may trigger deep market disturbances if the hedge fund has to reduce its positions abruptly. This may cause segments of otherwise healthy markets to ‘dry out’ and leave other participants unable to balance out their positions. In addition, the prime brokers which have lent to the fund risk losing their money. The destabilization potential of hedge funds rises with the rate of external capital they deploy. Less dramatic, but equally extensive effects are triggered by the so-called ‘herding’ of hedge funds. As hedge funds are responsible for a good part of the daily transaction volume, ‘parallel’ investment behaviour may lead to decisive market disequilibria and liquidity squeezes. Especially in markets with less liquidity, there is the risk that even a single hedge fund can assemble the means to influence the prices of financial instruments and thereby influence the behaviour of other participants, which in turn triggers market dynamics that are in the interest of the respective hedge fund. Such behaviour increases the volatility of the market considerably which endangers the stability of the financial markets.
Single investors have to be aware of the risk of total loss of their assets because of the highly speculative investment strategies employed by hedge funds. Additionally, the strong dependence on the skills of the fund manager puts the assets at risk of individual mistakes. Moreover, an evaluation of the assets of a hedge fund may prove difficult, especially in relation to investments which are only traded rarely or not regularly. Often, the hedge fund manager has significant autonomy in evaluating the fund’s assets. Given that performance fees depend on the manager’s own evaluation of the assets there is an obvious risk of abuse of that autonomy.
4. Legal and regulatory developments in the EU Member States
A large number of EU Member States have already enacted national provisions regulating hedge funds. These include limitations on selling hedge fund units to certain investors and on specific investment behaviour of hedge funds as well as transparency provisions. The UK Financial Services and Markets Act (FSMA), for example, contains specific provisions for collective investment schemes (ss 235 ff). Under these rules it is, for example, forbidden to publicly distribute unregulated collective investment schemes, which includes hedge funds. Additionally, such unregulated collective investment schemes have to comply with special accounting and publicity obligations (FSA Handbook, COBS, 18.5.5 ff). On the other hand, hedge funds do not face restrictions in relation to their internal organization and business activities as long as they adhere to the rules applying to all market participants (eg abstaining from market manipulation). Hedge funds are also regulated indirectly through regulation imposed on hedge fund managers and prime brokers. For example, the FSMA authorization requirement also covers hedge fund managers (ss 19 ff FSMA and Arts 37, 53 Regulated Activities Order). Prime brokers are usually registered as investment banks and no additional license to operate as a prime broker is required. Their services and operations, such as security trading, lending and extending security grants, are regulated activities (see especially Art 25 Regulated Activities Order).
Other European countries have also enacted special provisions on hedge funds. For example, the German Investment Act (InvG) contains special rules on hedge funds in §§ 112–120. Inter alia, the rules prohibit the public distribution of hedge fund units (§ 112(2) InvG). Hedge funds have to diversify their risk, and their investing in companies and real estate is subject to limitations (§ 112(1) InvG). However, like rules in other EU Member States, these national provisions are of limited impact as most hedge funds are registered outside of Germany. Only UK law has some relevance, as the majority of European hedge fund managers and prime brokers are located in London.
5. Regulatory developments on the EU level until May 2011
On the EU level, the regulation of hedge funds had been on the agenda for quite some time. In January 2004, the European Parliament adopted a resolution on the future of hedge funds and derivative financial instruments. This resolution named some risks of hedge funds and demanded, for example, the implementation of risk controls and sound supervision of hedge funds (which it termed ‘sophisticated alternative investment vehicles’ (SAIV)). Overall, the resolution took a positive view of hedge funds in general and articulated a preference for light regulation. In July 2005, the European Commission published a green paper which contained initial considerations for the regulation of hedge funds. A subsequent White Paper published in November 2006 contained only a few suggestions which took a more negative approach and focused on the risks of hedge funds. Despite this negative assessment and the premonitory remarks of the European Central Bank in its Financial Stability Review, the European Commission had not yet commenced the process of regulating hedge funds. Accordingly, the Parliament, in a resolution dated July 2007, asked the Commission to prepare suggestions on the regulation of hedge funds. Compared to the 2004 resolution, the Parliament took a more interventionist approach. It expressed its concern about the systematic risks of hedge funds and expressed its agreement with the concerns of the European Central Bank. In May 2007, the Economic and Financial Affairs Council (ECOFIN) intervened. It acknowledged the contribution of hedge funds to the efficiency of financial markets but focused primarily on the risks they brought to the financial markets. Concerning possible legal provisions, the Council favoured indirect rules for hedge funds. Since the beginning of the financial crisis in mid-2007, the issue of regulating hedge funds has assumed greater prominence on the agenda of the Parliament. In April 2009 the Commission issued a proposal for a directive on alternative investment fund managers which was intensively discussed and altered several times until it finally became the AIFM Directive passed in May 2011.
6. Intermittent self-regulatory developments
In the meantime, hedge fund managers set up the so-called Hedge Fund Working Group and drafted Best Practice Standards for the hedge fund industry which were published at the beginning of 2008. These standards are thus far preferable to any other approach to regulate hedge funds. The Best Practice Standards show an awareness of the key issues relating to hedge fund practice covering topics such as disclosure, valuation, risk management, fund governance and shareholder conduct. Although they lack legal force, they draw their authority from the fact that many well-known hedge fund managers have participated in their formulation. The standards adopt a ‘comply or explain’ approach, requiring a hedge fund that has signed the standards but deviates from them to explain its actions. After the publication of the Best Practice Standards, the Hedge Fund Standards Board was set up to act as custodian of the Best Practice Standards and to promote conformity to the Standards.
7. The AIFM Directive of 2011
The finally adopted and so-called AIFM Directive (Dir 2011/61/EU of 8 June 2011, OJ L 174/1) introduces harmonized EU rules for entities engaged in the management of alternative investment funds (AIF), such as hedge funds and private equity firms. The aim of the directive is to establish ‘common requirements for the authorisation and supervision of alternative investment fund managers (AIFM) in order to provide a coherent approach to the related risks and their impact on investors and markets in the EU’ and to allow ‘AIFM to provide services and market EU funds throughout the EU single market, subject to compliance with strict requirements’ (Press Release, 27 May 2011 of the Council of the EU). In addition to hedge funds and private equity funds, the directive also regulates real estate funds, commodity funds and all other funds that are not covered by the UCITS Directive (directive on undertakings for collective investment in transferable securities).
The main regulations of the directive are: (1) AIFM have to obtain authorization from the competent authority of their home Member State. Therefore they are required to have a minimum level of capital in the form of liquid or short-term assets. After authorization, AIFM will be entitled to market funds (established in the EU) to professional investors throughout the EU (‘passport’). (2) AIFM have to ensure that their funds appoint an independent (usually EU based) depositary who will be responsible for overseeing the fund’s activities and for ensuring that the fund’s assets are protected appropriately. (3) Further, AIFM are required to ensure a robust risk management and have to disclose regularly the principal markets and instruments in which they trade, their principal exposures and the concentrations of risk. (4) With regards to investors, AIFM are required to provide a clear description of their investment policy, including descriptions of the types of assets and the use of leverage. (5) The directive introduces specific requirements with regard to the use of debt to finance investment (so-called leverage). Competent authorities may set limits on the use of leverage, and AIFM have to disclose their aggregate leverage and the main sources of their leverage. (6) If AIFM acquire a controlling stake in a company, they have to comply with specific provisions, inter alia, the requirement to disclose information to other shareholders and to the representatives of employees of the portfolio company. (7) The directive gives Member States the option to abstain from applying the directive to smaller AIFM, ie leveraged funds with managed assets below €100 million and non-leveraged funds with assets below €500 million. Such funds, however, still have to comply with minimum registration and reporting requirements.
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