Expect 20 hedge funds to collapse each year, warns FSA

The Times December 09, 2006

Patrick Hosking, Banking and Finance Editor

Call for more information on fees
Promise to look at relaxing rules

Day of the locust

More than 20 hedge funds are likely to collapse each year, the chairman of the Financial Services Authority predicted, as he called for more transparency from the industry.

Sir Callum McCarthy said that the failure rate of hedge funds was relatively small at 0.3 per cent, but, with 8,000 funds worldwide, “we might expect slightly over 20 to come to collapse this year”.

The chief City regulator called on the industry to provide more information on fees, redemption penalties and other opaque areas before plans to open it up to small investors.

It was “increasingly anomalous” that UK retail investors were prevented from investing in funds of hedge funds, he said, promising a consultation early in 2007 to relax the rules.

Referring to the implosion of Amaranth Advisors, the American hedge fund that lost its investors about $7 billion (£3.6 billion) in September after being wrongfooted by naturual gas prices, Sir Callum said that investors had been undaunted by its failure. He said that the FSA was relaxed about hedge fund failures as long as there was no danger to the stability of the financial system. Addressing fellow regulators in Germany, Sir Callum tried to diffuse German hostility to hedge funds, arguing that demonising the industry was to miss the point.

Hedge funds were converging with so-called traditional fund managers and many banks, brokers and insurers were already carrying out trades indistinguishable from hedge funds.

In an oblique reference to one senior German politician’s famous attack on hedge funds as “locusts” two years ago, Sir Callum said: “Luckily. . . I am a regulator and not an entomologist.”

Sir Callum called for hedge fund managers to spell out details of their fee structures. Typically they charge 2 per cent of funds under management plus 20 per cent of profits. Yet the true cost to investors is often buried in complex conditions governing hurdle rates of return and allowable expenses.

“Any hedge fund manager, like other asset managers, should disclose these clearly to potential investors,” Sir Callum said.

They should also fully disclose redemption arrangements, including the existence of so-called side letters, documents conferring favourable terms on some investors. There also needed to be more detail on valuation procedures, a controversial area for hedge funds that often own illiquid assets for which there is no market price. Sir Callum said there was “potential for dishonesty” in valuing complex instruments like collateralised debt obligations and catastrophe bonds.