Directive on Alternative Investment Fund Managers - European Union Committee Contents

Examination of Witnesses (Question Numbers 420-439)

Dr Patrik Edsparr, Miss Rebecca Fuller and Mr Adam Cooper

24 NOVEMBER 2009

  Q420  Chairman: I suppose that the thing about the alternative investment community is that it has grown so much in the last 20 years and we have had some anecdotal evidence to suggest that the hedge fund community is now so big that, in the ordinary course of business without doing a single thing you could frown on, they are big enough to destabilise some of the big investment banks if they all withdrew funds at once as I believe happened.

  Dr Edsparr: I think the causality goes the other way. The reason that there was some strain on the hedge fund community was that the big banks withdrew the funding, because obviously the whole financial system is based on the central bank providing emergency liquidity to the major banks, and when the banks do not intermediate in that liquidity extension then the people who are beholden to the banks as intermediaries are exposed. That may be a separate subject matter, but I think that there is a legitimate question about how the liquidity provision in today's marketplace should take place and it may not be optimal that it always just goes through the window and through the major commercial banks. I think that the hedge funds are at some level dependent on the financing arrangements that largely happen through the banks. If the banks have access to liquidity from the Bank of England or the ECB or the Fed but the banks start to hoard cash and start to cut all the financing lines, it does not matter whether you are a hedge fund or if you are a corporation or if you are an individual because, if those financing lines disappear, most of those participants have no other source of financing. It is absolutely correct that that would cause some strain for some people including us but I think that systemically the demise, because of that withdrawal of liquidity and withdrawal of financing, actually did not any cause any systemic threat.

  Q421  Chairman: I think that we were reasonably convinced that the banks had not suffered, but the banks had, on the whole, got their money back from hedge funds and hedge funds have gone down. Are hedge funds in a position of holding large deposits with banks that they withdraw or can withdraw or might have withdrawn?

  Dr Edsparr: I think that this ties to the prime brokerage issue. I think that any well-managed hedge fund will have a very significant proportion of their assets in an extremely liquid form and, for a number of hedge funds, that means holding cash on deposit with their prime broker. I think that the demise of Lehman Brothers was disturbing to a number of people because they could not access that cash/liquidity reserve. It is absolutely part of prudent risk management to keep a very substantial portion of your assets in cash or cash equivalence to be able to meet short-term troubles.

  Chairman: Indeed.

  Q422  Baroness Northover: Picking up on My Lord Chairman's first question which was, had they grown to such a size that they could have a systemic effect, you then turned that around and said that actually they were affected by what happened. If they do indeed hold large deposits in the way that you say, if funds were to decide to withdraw these deposits, that could have a systemic effect, could it not?

  Dr Edsparr: I do not think that hedge funds represent any significant portion of the deposit base for the banks. That is very, very marginal. The hedge funds are net recipients of financing. On average, hedge funds own more assets than they have equity, so they need financing on some of those assets, and that is where the banks typically play a role. The only area where hedge funds can significantly contribute to systemic risk is if one particular position, let us say the insured Bank A versus Bank B, if it just happens to be that a lot of hedge funds at the same time as many of the banks and as maybe many of the traditional players, assets managers, insurance companies and so on, if they all end up having the same position, maybe out of coincidence or for whatever reason, I think you can argue that that can create technical pressures in the market.

  Q423  Baroness Northover: Of course that was something which was seen and addressed, was it not, that short selling seemed to be undermining institutions where there was some sort of a question mark?

  Dr Edsparr: My view, and speaking as a trained economist I guess, is that short selling is actually one of the few safety valves we have against bubbles. I find it intellectually very disingenuous, on the one hand, to say that we want to prevent bubbles, we want to prevent excessive speculation and risk taking, which are largely driven by long positions, borrowing to buy more and keeping the asset values going up and, on the other hand, to say that when those bubbles correct the short sellers are the damaging force. Short sellers keep those asset bubbles within some rhyme and reason when you have a bubbly market.

  Q424  Baroness Northover: What pops the bubble?

  Dr Edsparr: There is a combination of technical factors and fundamentals that pop bubbles. I cannot say that I have any secret insight as to when that happens, whether it is tulips in Holland or real estate in the US suburbs or, as a Swede, I guess I have a little bit of perspective from the Swedish real estate prices in the early 1990s. I do believe that short sellers play an extremely valuable function in forming efficient prices in the marketplace and I think that there is a crucial difference between saying that, in one particular name and at one particular time, the number of positions add up to too much, so that it is justifiable for a regulator to say, "Well, let's stop now in this name" as opposed to any kind of blanket restrictions.

  Q425  Lord Haskins: The logic of what you said about the hedge fund reliance on the banks for their cash would suggest, if you regulate the banks properly, that is where the systemic risk arises and, if you do that properly, then the banks themselves would be the regulator of the hedge funds because they are the ones who provide the money and, if they are providing money in an irresponsible way, then it is the banks who pay the price. You could argue that there are other reasons for regulating hedge funds but systemic risk does not appear to be one.

  Dr Edsparr: I would largely agree with that. I think that the key in this equation is the capital structure and the regulatory regime around banks and obviously that filters through to the access to leverage and financing for other participants. I would say that it is the regulatory regime around banks on the one hand and the access to emergency liquidity from the central banks which are the two macro-levers that, as regulators for setting the stage for the financial market, I believe are the two key features.

  Q426  Chairman: I was trying to establish whether hedge funds are now large enough that if, in the normal course of business and perfectly legitimately, they remove all their cash deposits from the banks because they are worried about the banks, they would be large enough to destabilise the bank? I think you thought not, Dr Edsparr.

  Dr Edsparr: I do not believe so. Also, remember that, if you do not keep any cash on hold, you will not be able to borrow anything against your assets. Effectively, if you want to do that on a bigger scale, you would basically just collapse your business.

  Mr Cooper: If I might add in response, the US regulators in particular are looking at enhancing the capital requirements applicable to banks so that they are required to post more capital, maintain more equity against their balances. What I think we found in the fourth quarter was that the system was under-capitalised and the banks had not reserved sufficient equity capital against their obligations and certainly great scrutiny is being put into that right now.

  Q427  Chairman: They were, in short, relying too much on their depositors?

  Mr Cooper: Yes.

  Q428  Lord Trimble: There are US proposals as well as the EU proposals which we are looking at. I wonder if you could give us an indication of how the two sets of proposals differ.

  Mr Cooper: Broadly speaking, I think they have similar goals of enhancing investor protection and guarding against systemic risk. The approach that the EU takes vis-a"-vis these issues as compared with the US approach is, however, slightly different. The US approach—and again these are all just proposals now that are being considered—is based more on transparency, information and disclosure. I believe that the EU proposals are more prescriptive and rule based in nature.

  Q429  Lord Trimble: If the EU proposals are more prescriptive rather than just being on the questions of transparency and disclosure, could this then result in a situation of these two regulatory structures developing in the way you have said, which is actually then going to be a commercial advantage for New York based businesses and, consequently, EU businesses might suffer as a result?

  Mr Cooper: You may be getting at the notion of, should there be some form of equivalency among regulatory regimes? I am not aware and I am not privy to the inner thinking of the regulators in this. I do not think there is any notion that they are trying to create a regime that would encourage regulatory arbitrage. I think what we saw more than anything in the fourth quarter of last year was the absence of harmonisation in communication among international regulators exacerbated. I think that there is a great drive now to harmonise the approach. You do not want to have the culture of a prudential regulator in jurisdiction A impacting a decision of where a participant goes if the culture of a prudential regulator in jurisdiction B is different.

  Q430  Lord Trimble: If we are going to harmonise the regulatory structures and we have US proposals that are concentrating on transparency and EU proposals that are a little more rigid in terms of their operation, how is one then going to harmonise?

  Mr Cooper: I think that there is a process in place where the regulators speak to each other. It is an aspiration; it is not necessarily something that can be achieved. I think that the best outcome though is an outcome that permits alternative investment fund managers to operate efficiently and smoothly in multiple jurisdictions. We are an international institution, we operate all over the globe, and it is important for us to be able to continue to keep doing so rather than to be arbitrarily precluded from one particular jurisdiction because of the absence, for example, of equivalency.

  Dr Edsparr: I would add, also, that the ultimate decision makers obviously are investors. It is the investors, whether they sit in Asia, the Middle East, Europe or the United States, in terms of tax treatment and in terms of legal treatment. There are all kinds of reasons why you can only operate efficiently in one environment and I think that, in all these proposals, the devil is in the detail.

  Q431  Lord Haskins: If we go into a little more detail on the two approaches to regulation, basically the proposal that the EU are putting forward and, you know much better than we do, the proposal being discussed in America. It seems to us that there seem to be three or four areas where they differ and I would like to get your comment. One of them is possibly different leverage requirements of the two regimes; the second one appears to be very important and is a moving scene and that is third-country investment and even the EU will tell you it is changing its position day by day on that; and the third one is a little related to that and that is marketing and scope of hedge fund activities.

  Mr Cooper: I will speak briefly and then turn it over to my colleague, Miss Fuller. The EU proposal, as you suggest, would prescribe leverage, marketing and third party services in third countries as well as depository and marketing limitations. The US provisions that have been proposed do not prescribe or address any of those issues in the same way that the EU does. There are no mandated leverage limits or restrictions under any US proposal. There are some slight proposals with respect to marketing but, by and large, EU managers can market freely in the US their investment products provided that they become registered as investment advisers as US managers must.

  Q432  Lord Haskins: Is that easy to achieve?

  Mr Cooper: Yes, I believe it is. These are just proposals, but I am confident that the US will pass legislation requiring investment advisers to register and I think that the rules and the way in which they are satisfied will be equally convenient or applicable to US and non-US managers, and then we permit them to freely market within the US provided that they maintain compliance with various marketing and private placement rules that exist. These are all private investment funds, so it is not a public offering to retail.

  Q433  Lord Haskins: Do you think that, if the proposal goes through, the gap in approach between the two regimes is widening or narrowing? We keep hearing that it is important that hedge funds can trade freely across the world. Is the gap in approach widening between the two regimes or narrowing?

  Mr Cooper: I would like to defer again to Miss Fuller with respect to the EU Directive, but some of the prescriptions of the EU Directive I think would make it very challenging for an international institution to freely deploy capital throughout markets in the EU.

  Q434  Lord Haskins: Including the recent Swedish compromise on third country private placement?

  Miss Fuller: I think that the third country private placement under the Swedish compromise text is definitely a step in the right direction. What remains unclear though is the ability of offshore managers to continue to market through the private placement regime into the EU and, just standing back, conceptually, nevertheless it is still going to be more difficult for third-country funds to be marketed in the EU. The Swedish text is definitely a step in the right direction but it is still a move away from the status quo which relies purely on the national private placement rules.

  Mr Cooper: If it is harder to market, I think it is ultimately the investors in the EU who suffer the consequences of that with the absence of alternatives in deploying their capital.

  Q435  Lord Woolmer of Leeds: Picking up that point, 80 per cent of funds managed by alternative investment fund managers are outside of Europe, overwhelming through the United States. I suppose that one could say that United States fund managers can do without Europe but European fund managers might find it not quite as easy to do without the United States and the rest of the world. In other words, if Europe has a regime that is tighter and much tougher and more regulatory than the United States, that could result in relative damage to investors in Europe compared with elsewhere in the world. First of all, is that a fair assessment of the way in which things could be going in Europe compared with the United States? It would be helpful to know that. Secondly, coming back to the point of arbitrage, if there are real differences, taking up Lord Haskins's point, will the result be arbitrage or simply less business and less opportunities and choice for European investors, pension funds and so on?

  Dr Edsparr: I believe that there are two aspects to this and you touched on both of them. I think there is one question of where you can conduct business as a hedge fund and the second issue is where you can attract capital from. If I may start with the latter one, I think it is clearly one of the issues in the current draft EU Directive to what extent international funds can market and engage European investors. Ultimately, the concern that I have as a European is that sophisticated institutional investors in Europe will not have access to some of the state of the art investment products. Obviously, 2008 and early 2009 created an enormous strain on the system and hedge funds, along with a lot of assets, went through some extreme gyrations, but I think the basic premise that they provide value-added returns with relatively low correlation with the other major asset classes is still the outcome and it is the common conclusion based on any kind of statistical econometric analysis. I think it would be very unfortunate if the European investors, the pension funds and the rather larger more sophisticated investors, were not to have access to those products because of the regulatory regime. I think that there is a second discussion obviously where you can conduct that business and, yes, in order to protect your investors, you have to find a reasonable regime to operate under.

  Q436  Chairman: May I ask again about the latest Swedish draft. If the private placement regime remains in place—and I appreciate that in the present version private placement, as in the Swedish Presidency's draft, remains in place—accepting that it is not as good for American investors as the existing regime, will it drive away hedge funds provided the private placement regime remains in place? I think it is the general European assumption that while the Commission would rather have a proper equivalency regime, if that is not possible the maintenance of national state private placement regimes will enable hedge funds to go on operating.

  Miss Fuller: My view is that the maintenance of national private placement regime is the pragmatic solution on the table with respect to the marketing issue. However, I do think that we need to be somewhat careful with respect to what the Swedish draft has and has not achieved, though certainly a number of steps in the right direction. However, it remains unclear whether managers who are based outside of the EU managing funds outside of the EU will, going forward, be able to avail themselves of the private placement regimes. Certainly for managers who are based within the EU managing off-shore funds, the private placement regime will be maintained to an extent, although I note that the Commission is due to review that three years into the operation of the Directive. So, I think, yes, as an outcome, maintaining private placement regimes is a good result, but we have to be somewhat careful with respect to the detail.

  Q437  Lord Woolmer of Leeds: The latest Swedish draft of the Directive suggests or proposes certain restrictions and conditions on the payment of bonuses in the alternative investment fund management field. What is your understanding of the current position as proposed by the Swedish Presidency and would you care to comment on the proposal as you understand it?

  Dr Edsparr: My belief is that this is something that is very much at the heart of the discussions between investors and fund managers and I think that fee structures for different products are intensely debated between investors and managers on an ongoing basis, along with a range of other issues, and are very much negotiated in the context of that relationship. There is a huge difference between privately held institutions dealing with sophisticated international investors determining what is fair compensation for different services and, let us say, the remuneration debate around institutions that received explicit government aid. I feel that there is a legitimate desire from investors to have a tight link between the timing of realisation of profits with the timing of the remuneration. I think that is something that permeates the hedge funds and private equity communities and I believe that all the events of the last couple of years have made those links tighter and much more precisely defined. What I am referring to is, obviously, that if you make an investment today and the realisation happens three years from now, people should primarily get compensated on the ultimate resolution of that, not on some intermediate mark. Personally, I believe that most of the excesses which took place in the system were when that close link between realised profits and remuneration was broken because positions were kept on the books for a very long time. I do not see that it is appropriate for a regulator to dictate that. It is a very dynamic environment and it is, as I say, negotiated on a daily basis.

  Q438  Lord Woolmer of Leeds: You know that the public are greatly concerned about the issue of reward and excessive reward which is apparently related to excessive risk taking. What is your answer from the point of view the alternative investment fund industry because they would say, "We hear what you say, nevertheless these are tough times and there should be seen to be some restraint"?

  Dr Edsparr: My answer would be that, unlike banks and large public institutions, most of the principals in major hedge funds have very significant amounts of, if not most of, their net worth tied up in exactly the same product as their investors. There is no misalignment of interest between the investors for whom you work and your own remuneration. It is not as if, I can book things in a non market-to-market bank book (available for sale—AFS) that sits on the books, for ten years while I will get my bonus in a year or two. Most senior principals in the hedge funds community have a total alignment with their investors through their own pocket books. It is a simple discussion between serious experienced investors and serious investment professionals to determine what is a fair compensation structure for different services/different products and it is very much at the heart of these discussions.

  Q439  Lord Woolmer of Leeds: Are there any proposals in the United States to cap, restrict or regulate payments of bonuses in the alternative investment fund industry?

  Mr Cooper: There are none.

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