Hedge Funds Facing The Regulatory Challenge

by Carla Johnson, InvestorsOffshore.com, London

08 January 2002

After a year in which hedge funds grew up from being rich men's playthings to adolescence as the thinking man (and woman)'s investment of choice, they can no longer hide from the spotlight of regulatory examination but must take account of the new importance placed everywhere on 'knowing-your-customer' and turning away business from bad guys (and, let's be even-handed here, gals!). Or must they? It's an agonising question for the previously secretive funds which operate in a dimly-lit 'alternative' investment world where riches grow in the shadows, like the juciest mushrooms.

The industry's lobbyists and leaders are in fact preparing a set of guidelines designed to keep would-be money launderers away from previously easy going funds that cared more about the thickness of your wad than its provenance. Many of the banks which place their customers money into hedge funds have indeed attracted it in the first place with promises of secrecy.

Rather than sit back and wait for government regulators to tell them what to do, hedge fund promoters are working with authorities with the aim of making sure future laws will be to their liking. "We have drafted something that could be a component of a broader best practices document and the first part, that would be an identification of customers, might come out in January," said Patrick McCarty, general counsel of the Managed Funds Association.

Reception of the guidelines in a notoriously free-wheeling industry is anything but guaranteed. Five years ago, when there were just a few hundred funds, it would have been much easier to gain a consensus on necessary measures; now, with 1,000 new funds setting up shop last year alone, swelling the total number of funds to about 6,000, many or even most of them offshore, it will be far more difficult.

Some industry leaders are optimistic: "Because hedge funds make it their business to stay out of sight, they are often a favorite scapegoat and this is an opportunity to gently get their name in a more positive light," said Mark Silber, vice president at hedge fund Renaissance Technologies Corp.

The funds will likely be asked to record clients' names, addresses and nationalities and share suspicious information with intelligence agencies. For hedge funds, which generally have fewer than 100 investors, this would be an easy and obvious way to comply with the so-called US Patriot Act, which covers the entire financial services industry.

But many funds fear screening clients could be bad for business. Only a handful of funds have so far put their money where their mouth is and told clients to identify themselves or risk having their money returned. Silber's fund is one of few that adopted stringent provisions and irritated some clients when it refused to take nominee accounts, which are popular in Europe.

"Am I going to have to check out every client of every bank who invests with me or will it be enough to have a bank tell me they are satisfied there are no terrorists on board?" asked one manager. "If I have to put in some huge risk management team to do that, that would outnumber my traders and the costs could kill me."

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