Remuneration: Another attack on the hedge fund industry
Stifling innovation and industry in the financial heart of London appears to be a recreation of choice among some figures in the European Union (EU) at the moment.
The Capital Requirements Directive (CRD), which was agreed by the European Parliament and European Council of Ministers in July 2010, is going to disproportionately impact hedge fund managers when it is implemented by the UK’s Financial Services Authority (FSA).
The FSA plans to update its existing remuneration code to take on board the European requirements that will come into place on January 1, 2011. The proposals will force hedge funds and other financial institutions, including all asset managers and Ucits investment companies to curtail the bonuses they award.
As things will stand, at least 40% of a bonus must be deferred over three years. If a bonus exceeds £500,000, at least 60% must be deferred. In the initial European Parliament press release, there were also indications that cash bonuses would be capped at 30% with a 20% cap for ‘particularly large’ bonuses.
Notwithstanding the merits of these new provisions as they will apply to a banking sector that survived only thanks to taxpayers’ money, it is misguided for these proposals to be imposed on hedge funds. The initial purpose of the legislation was to prevent major investment banks from taking unnecessary risks with capital from their retail customer base. This is understandable – banks were taking significant risks using other people’s money, and these actions needed to be curbed. However, to target hedge funds as part of the banking clampdown is wrong and not in the interest of the broader public.
There are two reasons why alternative asset managers have possibly been targeted – one – politicians are unable to grasp what they are dealing with and don’t understand the concept of hedge funds and - two – hedge funds are an incredibly easy target for politicians to attack, being perceived as a tool for the rich. It is regrettable that hedge funds are not seen as a positive contributor to our pension plans.
Regardless of the rights and wrongs of politicians targeting the sector - is imposing remuneration on hedge funds actually going to do anything constructive? The simple answer is – no! Forcing hedge funds to adopt a remuneration policy will do nothing to protect the general public for a multitude of reasons.
Firstly, hedge funds are not investment banks – their actions do not impact unsuspecting individuals who are unaware of how their money is being utilised or invested. Hedge funds are private vehicles whereby clients have agreed to put their money in the hands of a manager adopting a certain investment strategy. Investors into these private funds have agreed to any potential risk or losses that may be incurred by that manager. These investors are sophisticated – they will or should only invest after carrying out appropriate operational due diligence and will review trading strategies adopted by managers thoroughly – in short, such sophisticated and institutional investors ought to know what they are doing when they put their money into a hedge fund. They should have a solid perception of risk when making their investments. For many investors this was a very material protection against traditional long only strategies.
Secondly and more importantly, hedge funds do not pose a systemic risk to the broader financial system – unlike the major investment banks that caused the crisis. The Alternative Investment Management Association (AIMA), the industry body representing hedge funds, has been incredibly proactive and effective in putting this view across.
This law is therefore unfairly painting banks and hedge funds with the same brush. Not only are hedge funds not giving rise to a systemic risk but the people that put money in them have the means to know full well what they are doing.
Furthermore, the law doesn’t actually address the problem of reducing risk. The premise of the legislation assumes that managers are paid accordingly to what they make which would entice them to take risks to earn more. This ignores the fact that anyone in the market who takes excessive risks is just as likely to lose as much as they gain. Any fund manager that loses cash therefore won’t get a bonus anyway. The law in this respect will not change much for hedge funds. There may be some benefits in reducing the short term focus of some managers. Short termism has indeed tended to benefit managers who take an annual performance fee, for example. They can earn large performance fees in one year even if they lose the capital the following year. However, the law on remuneration does not directly address this either.
The consequences of the remuneration policies on hedge funds may nonetheless be significant for the development of the alternative industry.
The new law will not only curb fund managers paying themselves and their staff but will also force them to make public disclosures about how much and how they are paid. This could cause new scrutiny from the media that may further embarrass an industry used as a scapegoat for the errors of central bankers.
It may also have an unexpected impact on the UK’s favourite form of hedge fund management company - the limited liability partnerships (LLPs), which are of course fundamentally different in terms of structure from limited liability companies. How will remuneration be applied to LLPs when the money is deemed to be owned by the members even if it is not received by them? This is something that needs to be urgently addressed and clarified.
Apart from the managers, who else stands to lose? Investors may suffer. While supportive of increased hedge fund compliance, investors are unlikely to approve of the industry becoming excessively regulated if this pushes it towards less innovation and compels only the larger managers to survive. It may also mean more correlation amongst the survivors. The sector could ultimately end up becoming a very uncompetitive environment to work in.
Promising managers hoping to start up their business today will get the short end of the stick. Start-up costs and ongoing compliance costs have increased exponentially over the last few years. New policies on remuneration, capital requirements and not to mention the impact of the Alternative Investment Fund Managers Directive could prove to be a serious deterrent to some budding entrepreneurs.
London is going to join the list of cities in Europe that could lose jobs as a result of the EU’s short sightedness. The city, after all, is a major hedge fund player and the location of choice for many international fund managers.
Whether this remains the case, is yet to be seen. Hedge funds are going to move out of London for a variety of reasons – although not solely because of remuneration. This is just the latest piece of continental legislation targeting alternative investment managers.
The beneficiaries of this European hedge fund onslaught are likely to be New York, Singapore and Switzerland – jurisdictions with friendlier free-market policies. Slowly and surely, London will lose its pre-eminence in Europe as a first class location for fund managers. Talented young employees will follow the new trends and move to where employers are going to be.
The sad reality is that this legislation is just around the corner. People may not like it but they do need to prepare for it. The authorities have effectively hurled these rules at the industry rather quickly giving them little time to get to grips with their impact or how to implement them.
To prepare for the regulatory changes, it is recommended managers sit down and draft the appropriate policies on how they should pay people and on what criteria that should be based. Another area to be addressed is putting in place a committee that will review the policy. This should not be a tall order or that expensive providing the fund management company is well organised.
At present, most fund managers are not viewing this imminent legislation as a priority. Unsurprisingly most asset managers’ focus is on raising assets and managing their funds. Nevertheless, more attention is going to be required to deal with the consequences of the potentially burdensome requirements coming to the fore.
Hedge funds are in an unfortunate predicament. Continental politicians view them as the enemy and don’t want to understand the numerous benefits the sector has to offer - for example, the tax revenues generated by the alternative investment management industry are impressive and help contribute towards many public sector services. Hedge funds also invest in emerging markets and lend money to corporates where banks are no longer active. Finally they help protect our pensions’ returns against the failures of the stock markets.
It is possible although somewhat tricky for the hedge fund community to address the provocations of EU politicians. The industry could be more professional about the way it conducts its lobbying and should seek the support of investors, most notably pension funds. At present, the hedge fund industry as a whole is rather shy and feels vulnerable. It also has to atone for the actions taken by some of its members who invested all too easily in correlated long bias strategies causing them hurt in 2008. Some of its members also breached the sacrosanct rule of trust that exists in financial matters, by misrepresenting what they were doing to naive investors.
Who will lead the industry forward is not obvious. It is unlikely to be a politician as the subject is probably too intricate to be understood by the majority of voters. Having said that, voters can see for themselves where their pensions are today and we may yet be surprised by their reaction. They may even start to blame governments for failing to rein in the central banks and give a welcome break to the hedge fund industry.
Jérôme de Lavenère Lussan is the founder and chief executive officer at investment management consultancy firm Laven Partners. The company, which has offices in London, Barbados, Luxembourg and Geneva, provides investment managers with guidance on fund establishment, regulation, compliance controls, risk management, operational due diligence and structuring. De Lavenère Lussan was previously a chief operating officer at a hedge fund and a financial lawyer at Jones Day.