Interview with the Hedge Fund Standards Board: Putting Power in the Hands of Investors

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1 Interview with the Hedge Fund Standards Board: Putting Power in the Hands of Investors Thamas Deinet, Executive Director for the Hedge Fund Standards Board (HFSB), speaks to IMR on its achievements to date, possible changes to the standards and the pressure for further regulation of the hedge fund industry. IMR: How would you sum up the progress of the Hedge Fund Standards Board to date? TD: The HFSB only became fully active in August 2008 after Antonio Borges became Chairman and I was brought in as Executive Director. We have since gained critical momentum with nearly 50 hedge fund managers signing up to the regime and we have full buy-in from the regulators. The Financial Services Authority s rules provide the regulatory framework for hedge funds in the UK with our regime sitting below but in the hands of market participants. We are not a regulator, but a standards setter. There is a growing consensus that the UK now has the right approach, with investors and managers driving standards in the industry. The key to our approach is the phrase comply or explain. When firms sign up, they commit to the standards on a comply or explain basis. This means that where managers chose not to comply with a given Standard, they must explain to their investors the reasoning. Investors can then judge whether they like the explanation or not and there can be many reasons for explaining. This mechanism avoids forcing all managers into one single way of doing things. The industry is simply too diverse and innovative for a one-size-fits-all approach. Clearly, if a manager does not comply with a given standard, and makes no explanation for that lack of compliance, they will be guilty of misrepresentation. As such, they will risk antagonising investors and losing money. Ultimately, the HFSB regime helps to strengthen the market place by enabling investors to make better informed investment decisions. We believe well-informed investors are best positioned to drive forwards industry standards and weed out underperformers or managers who do not meet high standards. Investors are fully aligned, and this is what makes an investor driven

2 The key to our approach is the phrase comply or explain. When firms sign up, they commit to the standards on a comply or explain basis. Thomas Deinet Hedge Fund Standards Board regime so much more powerful. It can even be more powerful and efficient than regulation. IMR: What is your own background? TD: I came in from Oliver Wyman, the management consultancy firm, where I worked with institutions across Europe in asset management and corporate and investment banking. In 2007, I orchestrated the consultation and drafting process for the Hedge Fund Working Group, chaired by Sir Andrew Large, and which led to the establishment of the HFSB last summer. Sir Andrew initially chaired the HFSB, too, but has now taken on an advisory role. Antonio Borges, who took over from him, is a former Deputy Governor of the Bank of Portugal, has been Dean of the French management school, INSEAD, and was most recently Vice Chairman of Goldman Sachs International. He is also Chairman of the European Corporate Governance Institute. IMR: What sort of firms have signed up to the standards? TD: We have a broad array of firms, from the small to the large. In addition to UK and US firms, we have Swedish, German, Dutch, Swiss and Spanish managers plus one from Hong Kong. It is a very international mix. The Standards are, tenets of good business conduct that are applicable worldwide. IMR: How has the new regime worked in practice? TD: Given that managers have mostly all worked through the compliance process independently, it has gone very smoothly. Now consultants are helping to share knowledge around the industry which is helpful. In practice, some firms have chosen to explain rather than comply with certain of the standards. But it is important to understand that this is not necessarily an inferior approach. Some of the standards, for instance, only apply to equity-related investments. At the other extreme, a number of managers have gone to the lengths of explaining in depth how they are complying, which we see as a positive move.

3 We have also noted an increase in investor pressure for firms to adopt and apply the standards. This is very encouraging. Investors are the lynchpin of the system. IMR: There have been parallel moves in the US this year following the report of President s Working Group. What impact has that had? TD: It has not changed our thinking. There are quite a few similarities between the two regimes, but the comply or explain philosophy is unique to the HFSB. It is interesting to note that US firms are among those that have enquired about becoming signatories. They like our marketbased regime. There is an element of soft law to all this, but, at the same time, we allow for the continual evolution and dynamism of the hedge fund industry. IMR: Does that imply that the rules are likely to change from time to time? TD: Yes. That is why the Board is in place. It is made up of both managers and investors to enable the marketplace collectively to move the standards forward over time. Moreover, the board also maintains an open dialogue with the other prominent members of the market, such as Citi, in order to stay abreast of developments in a proactive manner. Currently, we are looking at two areas a fairer approach to redemptions and the independence of fund administration and custody. We have a transparent process for making any changes. First the Board must agree a set of proposals. Then we consult our signatories and, finally, the proposals go out for public consultation. We are just completing the second stage of that process. IMR: What is the thrust of the proposed changes? TD: On redemptions, our approach has been shaped by the crisis that occurred in the second half of last year when it became apparent that there are perverse, and often self-feeding, incentives for investors to redeem even when they may not really want to. For example, if it looks as if a fund is suffering liquidity issues, some investors will seek to redeem while they still can just to ensure they are not locked in with the rump of the investments. That obviously works against the interests of remaining investors. There may also be a run on a fund because of a completely unwarranted fear that redemptions will be suspended. Then there is the situation where an investor puts in a pre-emptive redemption request concerned that a fund will invoke its gate provisions only to withdraw it later. That forces a fund to build up liquidity to no purpose, which may well have a cost in terms of performance. The investor, meanwhile, has enjoyed a free option at the expense of all the other investors. What we want to achieve is fair treatment for all. It is a complex area but it means making fund behaviour more predictable by, for instance, building a fund s gating policy in to its terms. As for the administration and custody issue, we are still in the process of finalising our proposals. But it is clear that the involvement of an independent provider, which is common in Europe anyway, is enormously important. IMR: How do you respond to the pressure for more regulation from the G20 and the European Union for instance? TD: These are very interesting times. We hope that policy makers will come to the right conclusions in terms of a reasonable approach. Despite all the discussion about market failure and the need for more regulation, it is important to remember that there has been no market failure in hedge funds. No hedge funds have had to be bailed out with taxpayers money. The scale of the issue needs to be put into context. Total assets of Despite all the discussion about market failure and the need for more regulation, it is important to remember that there has been no market failure in hedge funds. the global hedge fund industry are around USD1.5 trillion. That is no more than the total balance sheet assets of one major European bank. Meanwhile, leverage is currently around one-and-a-half times compared with around 30 times in the banking industry. In our response to the European Union s consultation on hedge funds, we made clear recommendations on how to tackle the micro- and macro-prudential issues that regulators and policy makers might be concerned about. The G20 s proposal is that either the manager or the fund should be regulated. We believe the FSA s approach is the right one to regulate the underlying manager. We hope that other regulators come up with a similar system.

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