When You Have Lemons, Make Lemonade--Page 2

How to Fix It: Increased Transparency
Transparency is paramount to any type of hedge fund reform. Hedge fund registration, as the current version of the Hedge Fund Transparency Act would require, is the first step. This bill would require funds larger than $50 million to provide basic contact, service-provider, and assets-under-management information in order to register with the SEC. Although this provision alone is fairly unremarkable, the bill opens the door for the SEC to take further steps, whether in creating new regulations or in subjecting hedge funds to inspections. Hedge funds of institutional-investor magnitude would fall under the reach of this act.

Indeed, the regulation needs to go further. Hedge funds should publicly disclose portfolios and leverage information over a regular interval (for example, quarterly) with a sufficient lag, to protect hedge fund managers from copycats, to allow potential hedge fund investors and third parties to assess the risks of the strategy, and to see if the hedge fund managers are living up to their words.

In addition, custody, pricing, and reporting of hedge fund assets through independent, approved third parties (banks or broker dealers) are necessary steps. Otherwise, we will find ourselves in another Madoff dilemma, where self-custody, self-reporting, and cronyism facilitated a massive fraud.

Critics argue that increased transparency and regulation will drive hedge funds to seek shelter in less regulated, manager-friendly domiciles. But crooks will always seek shelter in the shadows of regulation. We learned this lesson with foreign exchange, and now we are learning it with hedge funds. Institutions must not be so naive as to fall for this rhetoric again.

The transparency effort will have to be worldwide. Fortunately, the process is already under way. When Germany hosted the G8 summit in August 2007, it attempted to push through global regulation of hedge funds. Germany's calls fell on deaf ears then, but France has recently revived the effort. Governments still enabling hedge funds to be opaque, such as Luxembourg, are attracting heavy global scrutiny, while governments formerly considered secrecy havens, such as the Cayman Islands, already require registration and reporting of most funds.

Re-aligning the Wheels
To fix the problem of incentive misalignment, David Swensen, CIO of Yale's Endowment, offers a promising direction. Swensen, whose large fund and even larger reputation allow him negotiating power, takes the private equity approach to investing. He demands lower management fees from the funds in which he invests but, in return, offers the carrot of high performance fees upon realizing gains above a hurdle rate at the termination of the fund. In addition, he is willing to make concessions about the liquidity of his investment. This structure gives managers time to achieve their goals and a handsome payoff should they succeed, while eliminating fat short-term payouts for funds that prove to be longer-term failures.

The Utah Retirement Systems is one of the first to take on the realignment initiative. Instead of the standard fixed 2% and 20% fee structure, the Utah pension fund offers hedge fund managers a tiered fee schedule, with management fees and performance fees declining to 1% and 15% for investments over $50 million. Furthermore, it will only pay performance fees on new profits above a hurdle rate of Treasury Bills plus the management fee. Finally, in exchange for a larger initial investment, rolling 12-month lockups, and liquidity gates, the institution will defer payment of performance fees, paying out only 50% at the end of the first year and the remainder over the next two years if the profits persist.

With the backing of its peers (the Teacher Retirement System of Texas is already on board), institutions like Utah Retirement Systems could go even further. A better management-fee structure might be fixed at 1% annually, or it may decline as the fund's total assets grow, a common practice in the mutual fund industry. Incentive fees could be fixed at a high rate, for example 30% on new profits, above a more difficult hurdle rate, such as 8%, a common practice in private equity. Alternatively, performance fees could increase as the level of outperformance increases.

To be fair, lockups should also be longer--two years or more--especially for hedge funds in less-liquid or longer-term investments, such as distressed securities. Many investors accepted two-year lockups in 2005, when some hedge funds increased lockups to avoid impending (and subsequently failed) SEC registration requirements. We heartily encourage the continued growth of this trend.

It is time to rethink the hedge fund proposition. Institutions now have the upper hand, as they still have funds to invest and long time horizons, while many hedge fund managers are out of jobs. The credit crisis has already served to weed out many of the less-skilled managers, as the bear market has forced liquidations, leaving skilled managers in their wake. Going forward, institutions need to use their clout to demand better terms from hedge funds. Transparency, less money up-front, longer lockups, and more money on the back end would transform hedge funds from an industry of used cars into a fleet of luxury vehicles.

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