Hedge funds heeding message: Heal thyself

Financial planners who may be considering hedge funds for a slice of absolute returns in a choppy market can rest assured that regulatory oversight is as tight as it has ever been. Of course, it might also be worth mentioning that regulatory oversight of the hedge fund industry is essentially the same as it has ever been.

In other words, if you were shocked in 1998 when a gargantuan and wildly leveraged hedge fund known as Long-Term Capital Management LP nearly toppled over onto some of the world’s most fragile financial markets, don’t kid yourself into thinking that the government has fixed anything since then.

Not that regulators have ever been very welcome in this arena that is crowded with so many edgy entrepreneurial types who insist on holding their cards snug to the vest. Remember that hedge funds are private investment partnerships that are designed for use by rich people and institutional investors who can theoretically afford to lose some money.

And this brings us back to Long-Term Capital Management, the Greenwich, Conn., hedge fund that was ultimately bailed out by a consortium of more than a dozen financial institutions to the tune of $3.6 billion.

Even though it all unfolded ages ago in the dog years of the modern financial markets, Long-Term Capital remains significant for its impact on the way the hedge fund industry has been scared straight since 1998.

The latest evidence of how things have changed in this loosely defined class of alternative investments can be seen in the results of the “Review of Issues Relating to Highly Leveraged Institutions,” released last month by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

Don’t let the name fool you; the report is hard to read.

Sample sentence: “While in 1998, high levels of leverage were found at only a limited number of unregulated highly leveraged institutions, it appears that such leverage has since been significantly reduced.”

In other words, hedge funds aren’t borrowing as much money to buy securities as they were a few years ago.

The Basel Committee study, designed to be the culmination of more than two years’ worth of hedge fund industry studies conducted by everyone and their brother, set out to answer two basic questions: Should hedge funds be regulated investment vehicles? And should the financial institutions that lend money to hedge funds be subject to additional regulations?

The answers are no and no, because what the research found is that while nothing has changed officially, everyone in the industry is doing things differently these days.

No longer is the phrase “due diligence” defined as a casual lunch with the manager. And the financial institutions such as the ones that lent money so blindly to Long-Term Capital have introduced standards and guidelines for dealing with hedge funds, if they are in fact still dealing with hedge funds.

The hedge fund managers themselves have even warmed up to the notion of transparency.

Because nobody in the industry seems ready to suggest that we’ve seen the last hedge fund meltdown, most observers can admit that the changes made are a result of Long-Term Capital’s near-collapse.

“This was a good wake-up call for the industry,” says Jack Gaine, president of the Managed Funds Association. “There are more controls and risk management techniques in place now, and everyone is more careful.”

Ultimately, it comes down to what most people had believed all along, that hedge funds can not be roped in and regulated in the traditional sense.

Of course, nobody ever said hedge funds couldn’t be roped in by the notion of being regulated in the traditional sense.

Jeff Benjamin is the market columnist for InvestmentNews and a reporter in its Boston bureau.

Related Topics: Just Thinking