Another Prickly Hedge Story

by Carla Johnson, Investors Offshore.com, London

24 September 2007

After another torrid week for hedge funds, which saw investors locked out of seven funds run by Absolute Capital Management due to the discovery of unreported illiquid investments, calls are mounting again for intensified surveillance of the often murky sector.

In the absence of regulation or even a code of conduct for hedge fund managers, investors in the funds concerned, which had been run by Florian Homm, who resigned during the week citing differences of management philosophy, were effectively trusting the managers of the funds, which is a rather shaky basis for investment, it might be thought.

“Let me be very clear: I am no friend of hedge funds,” thundered Günther Verheugen, the European Commissioner for Enterprise and Industry to Der Spiegel. 'Takeovers by hedge funds regularly lead to the break-up of companies, ending with the sale or closure of company divisions, all in the name of an even higher return. Later it turns out once competitive companies were ruined and jobs wantonly destroyed.”

Absolute, which has about US$3bn under management, said that the problems applied to about US$500m of assets, and suspended redemptions after investors tried to reclaim US$100m of their money. Absolute said it had been surprised to learn that the funds had put money into the shares of small, micro-cap US companies which can only be traded in small volumes.

"The preliminary results of this review indicate that seven of the eight Absolute Capital equity funds contain quoted investments which the board believes are not immediately realisable at their stated values due to their illiquid nature," said the company. Its shares collapsed on London's AIM.

The company said that exposure to the micro-cap stocks varies from nothing in one fund, Absolute Large Cap, to 40-45% in the $342m Absolute Octane fund. It would like investors to agree to move the illiquid investments into a separate "sidepocket", which would be wound down over time, to avoid a fire sale of the microcap holdings. Jonathan Treacher, chief executive, who has only been in the job for a few weeks, said that the alternative is liquidation in the Cayman Islands, where the funds are registered.

Surprisingly, German Finance minister Peer Steinbrueck didn't take the opportunity to make the case for more hedge fund regulation. He even tried to calm jittery investors by stating that his initiative along with French Finance minister Christine Lagarde to improve transparency in financial markets would not involve regulation as such. They hope to persuade the banking and other financial sectors to agree to codes of conduct and other self-regulatory measures. He admits that any one country can't achieve anything by regulating, but sees that there is no traction for any attempt to impose global regulation.

Germany failed to get the G8 to impose a Code of Conduct on hedge funds at a June summit in Heiligendammin. Deputy Finance Minister Thomas Mirow says that hedge funds should be more transparent. And Bundesbank President Axel Weber says: “It is time to actively develop ambitious best practices maybe in the form of a code of conduct.” But he emphasized that he wasn't expecting any immediate action. “This is a medium- to long-term process,” he said. “What we want to do is to start a discussion process.”

Peer Steinbrueck has said he wants the outlines of a code of conduct in place by the end of this year, and he may yet get it: Jean-Claude Trichet, president of the European Central Bank, has said that a voluntary code could cover risk management within hedge funds and the exchange of information between funds and their bankers and between funds and their investors. And EU finance ministers, while agreeing not to regulate hedge funds, have spoken in favour of a code of conduct to guide their behaviour. New French President Sarkozy has consistently spoken out against hedge funds: "We didn't create the euro to have capitalism without ethics or morals," he said, attacking “these aggressive [hedge] funds ... that buy up a company, sell it off in pieces, sack 25% of the staff in the meantime, collect 25% profit and create zero wealth.”

The United States, Japan, Britain, and Canada remain opposed to any interference in the workings of the markets. "Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution," said Fed chairman Ben Bernanke in May.

Germany in particular has been pushing for greater controls over hedge funds ever since the Deutsche Boerse affair in 2005, which saw investors remove Chief Executive Werner Seifert and Chairman Rolf Breuer, leading the SPD's Franz Muentefering to compare the funds to locusts.

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