Hedge Fund Performance and Regulation

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The hedge fund industry has taken quite a hit over the past year, leaving institutional investors fairly disappointed with ROI expectations. Preqin, the industry’s leading investment analytics company cited its 2015’s aggregate 2.02% return as the worst since 2011. Preqin further reported that 44% of fund managers reported failure to meet return objectives. The hedge fund industry is no lightweight; globally the industry accounts for over USD3 trillion assets under management. Poor hedge fund performance is a strong indicator of how unstable the overall financial system has become, even though the industry is not considered a market maker. Both large and boutique hedge funds that pursued single strategy objectives bore the brunt of poor performance. Hedge funds that focused on equity, macroeconomic, managed futures and relative value strategies had the most fund closures for last quarter 2015. Funds with multi-strategy, event-driven strategies and credit strategies had the best overall performance, and a larger number of fund launches. On a positive note, the entire industry saw an increased transfer of capital flows from family offices and high-net-worth individuals in 2015. Evidently, private wealth investors have waning confidence in public capital markets.

Key-Drivers-Hedge
Table 1: Key Drivers of the Hedge Fund Industry. Source: Preqin Hedge Fund Manager Outlook 2016.

While performance and handling market volatility are key drivers for the overall 2016 hedge fund outlook, Preqin cites the number one concern among hedge fund managers to be transparency and risk management, with the need to adapt to new regulations. Hedge funds face conflicting tasks of handling increased costs of improved business infrastructure, while remaining cost competitive with investor fees, in the face of industry regulation. In October 2015 the Securities and Exchange Commission (SEC) found via spot checks that certain hedge fund managers were breaching fiduciary relationships with investors. Fund managers were found to be personally profiting from trades before executing trading strategies, while shrouding performance numbers in performance reports. The SEC has promised further compliance enforcement for private equity and alternative investment firms in 2016, and now mandates hedge funds to provide strict standard data upon registration with the SEC. All private equity funds and investment advisers must file Form ADV to provide fund size and organization structure with the SEC. Funds with at least USD150 million assets under management (AUM) must file an annual Form PF to update leverage, liquidity and investment criteria, and investment fees. The SEC posts all aggregate private equity data derived from reporting publicly, thus satisfying Section 404 of the Dodd-Frank Act’s financial and risk reporting requirements.

Historically, hedge funds needed to meet only Section 4(2) of the Securities Act of 1933 and specifically, the Regulation D safe harbor rules. Hedge funds need to especially adhere to Rule 502, which prohibited general advertising through media and meetings; Rule 505, which exempts offering registration of USD5 million or less, and requires no more than 35 non-accredited investors to be vested in the fund; Rule 506, which allows the hedge fund to offer an unlimited amount of interests to investors. In addition, hedge funds need to file a state-specific “blue sky” filing with the SEC 15 days from the date of an investment into the fund. Under SEC Rule 12(g-1) hedge funds did not have to submit frequent reporting if the fund had less than 500 accredited and non-accredited investors. Hedge funds have been very vigilant in following exemption requirements to avoid over reporting and registration.

Columbia Law School professors Wulf Kaal and Dale Osterle pinpoint why hedge funds have been subjected to further regulation in their blog article, The History of Hedge Fund Regulation in the United States. Long Term Capital Management’s 1998 failure put hedge funds at the forefront of regulation. Prior to LTCM’s bailout by the New York Federal Reserve Bank, hedge funds were not considered as main influencers of systematic risk. However, the SEC began inquiries to regulate transparency and quantify reporting data in the alternative asset management industry. Kaal and Osterle cite the SEC’s failure to achieve all hedge fund registration in 2006’s Goldstein v. SEC case, by which hedge funds were able to deregister and return to the original registration exemptions under the Securities Act of 1933. However, as Kaal and Osterle explain, Title IV of the Dodd-Frank Act finally allowed the SEC to enforce stricture hedge fund regulation, and mandated that the SEC create and enforce rules requiring investment advisors, private equity and asset management firms to complete registration and annual data reporting. Data must include planned strategy disclosure; all risk analytics, credit limits, fund manager positions, and leverage figures must be included as quantifiable metrics.

Fund managers will have a veritable balancing act for the entire fiscal 2016 with continued regulation, and a call for further transparency within the extremely performance driven alternative asset management industry. While hedge funds may not be systematic drivers of the global financial economy in comparison to big banks, the industry’s USD3.2 trillion size is no laughing matter. In addition, sovereign wealth funds are significant players in funding emerging market debt, as we have seen recently with Argentina’s bond debt settlements. While continued regulation is necessary for transparency, fund managers need to have adequate reign in focusing on fund performance, especially in such a volatile macroeconomic system. Fund managers have taken it upon themselves to focus on risk and transparency. Thus, we expect that current data reporting based on Title IV of the Dodd-Frank Act continue with no additional punitive requirements, so as to give hedge funds room for performance improvement in 2016.

REFERENCES

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Key Financial Regulations To Monitor

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Fourth quarter 2015 was a hard precursor to 2016 both in capital markets and financial corporate governance. Highly volatile commodities and equities markets, an overall slowing of economic growth and a cooling of tech business growth have left the investing landscape bearish. In addition, corporate governance of major financial and business institutions showed signs of increased shakiness; in 2015 HSBC took the governance world by storm with tax evasions, Bank of America and Citi continued to fail bank stress tests and capital requirements and JPMorgan’s stock has significantly underperformed analysts’ expectations. We now open the year 2016 with an SEC fraud charge against the entire executive management and Board of Superior Bank for overstating loan performance. In this light, 2016 will be a year of continued US Federal Reserve and Securities and Exchange Commission (SEC) financial regulation.
It is noteworthy to mention that the US Federal Reserve may raise rates for 2016. However, in this outlook we have decided to focus on specific regulatory requirements linked to the Dodd-Frank Act of 2010 and to Securities and Exchange Commission rules that will also shape the regulatory framework of financial institutions and corporations for 2016.Key regulations are as follows:

Capital Requirements and Asset-Liability Management:
The Dodd-Frank Act of 2010 has clearly stipulated capital requirements for financial institutions, of which systematically important financial institutions such as Bank of America and Citibank have failed within the past two years. For assurance that banks are better capitalized, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) plan to enforce further Basel III agreement factors, requiring higher leverage ratios and a larger liquid asset base. The Financial Services Roundtable, a top US Financial Service advocacy group, has cited the Net Stable Funding Ratio as the standout rule which banks will need to apply for asset-liability management to comply with Basel III requirements. The upside to continued monitoring of capital reserve requirements is financial stability. The downside is, of course, further dampening of bank earnings growth.
Single Point of Entry and Source of Strength:
In 2015 regulators called for stronger resolution strategies of 12 major banks operating in the US, to ensure that if these financial institutions needed to be liquidated there would not be significant strain on US financial stability. The Federal Reserve and FDIC have demanded that bank holding companies be able to be resolved within themselves as well as for all subsidiaries. Ten out of the twelve major banks have opted for the Single Point of Entry (SPOE) resolution strategy under Title I of the Dodd-Frank Act of 2010. Under this strategy, banks will rely on the holdings company as the major “source of strength” for all operating subsidiaries, before FDIC intervention. Sharon Haas et al. of Columbia Law School’s Corporate Governance Program explain that SPOE is different to the Bridge Bank resolution strategy, by which the bank automatically goes into receivership under the FDIC. The Financial Services Roundtable has stated that regulators will seek a firm implementation of the source of strength stipulation for banks in 2016.

Stress Testing and Risk Management For Non-Bank Financial Institutions

The non-bank financial industry is of equal importance to major banks as systematically important financial institutions. In 2015, the SEC played a major role in setting risk management parameters for investment funds, mutual funds and ETFs. Under 2015 amendments to the Investment Company Act of 1940, the SEC stipulates more stringent liquidity risk management, requiring set minimum cash and liquid asset quotas based on the fund’s net assets, with a three day time to liquidation. In addition, the Financial Services Roundtable cites more implementation of stress testing, securities disclosure requirements and qualified standard of conduct from investment advisors on all investment company types for 2016 via the US Department of Treasury’s Financial Stability Oversight Council (FSOC) in conjunction with the SEC, under Section 913 of the Dodd-Frank Act.

Executive Compensation And Clawback Policy

In 2015 the SEC majority voted to implement firmer requirements with regards to executive compensation within financial institutions and major corporations, in cases where the financial institution displays significant noncompliance with financial reporting standards. SEC Rule 10D-1, based on Section 954 of the Dodd-Frank Act, requires a corporation that seeks financial recovery due to an accounting restatement for compliance purposes to seek recovery from both current and former executive management who obtained “excess incentive based compensation” over the course of prior three fiscal years. Public companies are thus required to file a detailed clawback recovery policy with each 10-K. In addition to a stronger enforcement of SEC Rule 10D-1 in 2016, the Financial Services Roundtable cites a need to have a stronger enforcement of Dodd-Frank Section 956, which requires regulators set specific standards to “prohibit salary arrangements that encourage “inappropriate risks.”” To date a final draft on executive compensation guidelines for banks has not been produced; however, with the implementation of the claw back policy we expect to see more examination of executive remuneration by regulators in 2016.

Commodities Income and Payments To Governments

This SEC regulation is non-financial institution related. Regulations on tracking the income flow of oil trading are now a highlighted part of the regulatory landscape, given the commodities markets climate as well as the geopolitical nature of commodities trading. The SEC has proposed a rule to enforce Section 1504 of the Dodd-Frank Act, which requires “issuers that extract natural resources” to specifically delineate all payments, transactions and income made to the US government and to foreign governments for any commercial development of commodities. Elizabeth Ising et al. of Gibson Dunn & Crutcher LLP via Harvard Law Corporate Governance explain that all resource extraction issuers are required to publicly file an annual report stating all government payments, with only case-by-case country exemptions. This disclosure would be required of all holding companies and subsidiaries under the issuer. In addition to payment amounts, all fiscal years when payments were made, as well as the actual geographical areas linked to these payments will be mandatory to disclose. In a geopolitical atmosphere of terrorism funding linked to oil and commodity trading, it is most acceptable to see strong SEC commodities income disclosure requirements for 2016.
Sources

Haas, Sharon et al. 2015. “PwC discusses Resolution: Single point of entry strategy ascends.” The Columbia Law School Blue Sky Blog.

Hatch, Robert. 2016. “10 Regulatory Issues the Financial Industry Is Watching in 2016.” Financial Services Roundtable.

Ising, Elizabeth et al. 2015. “One More Time! SEC Seeks to Re-Adopt Resource Extraction Disclosure Rules.” Gibson Dunn & Crutcher LLP. Harvard Law School Forum on Corporate Governance and Financial Regulation.

Ising, Elizabeth et al. 2015. “SEC Propses Rules Regarding Clawbacks.” Gibson Dunn & Crutcher LLP. Harvard Law School Forum on Corporate Governance and Financial Regulation.

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The Activist Investor: A True Ally of Corporate Governance

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Activist investors: Publicly listed companies fear them. Corporate governance pundits generally do not trust them. Retail investors quietly applaud them, and most laymen do not understand them. However, it is clear that in today’s complex corporate world, we need them. Activist investors may be the only players in the game that can effectively “Occupy Wall Street”.

We have entered the twilight zone when it comes to corporate governance. The zone where many Boards bury their head in the sand when it comes to breaches in compliance, as in the case of HSBC and the tax evasion scandal of February 2015. Certain Boards passively bow to the dictates of executive management, throwing all accountability on the corporation-as-entity, with no individual responsibility. All other stakeholders, from shareholders, to suppliers, to workers, to humble taxpayers are left to peck at what is left of net worth after the share price dives, and are left to fork out money for regulation and reconstruction.

To be fair, in the recent past activist investors have been noted for short-termism. Short-termism is the process by which an activist fund may coerce target companies to conduct strategies that may yield high profit in the short term, but that may be detrimental to company performance in the long term. For instance, it is common practice for activist funds to demand significant reduction in Research & Development activities; yet, R&D is needed for long term competitive and innovative advancement. Most activist fund activity increases the stock market price of the target company. However, best practice professionals argue that the temporary increase in share price is misleading and cannot offset long term business hazards that occur if the activist investors short the target company’s stock. There is truth in this belief. However, we need to take a closer look at activist investors’ strengths when it comes to financial strategies and business growth.

Bernard S. Sharfman in his Columbia Business Law Review article Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value does an excellent job of delineating the benefits of shareholder activism and Board governance. The author’s main premise calls for an integral approach to investor activism in Board decision making, as opposed to the present “Authority Model” that exists within Board and executive management’s line of communication, a model that excludes shareholder participation and creates a passive acceptance of managerial decision making as ultimate, without proper analysis and foresight. Poignant highlights from Sharfman are as follows:

  • Shareholder activism can be defined as “any action(s) of any shareholder or shareholder group with the purpose of bringing about change within a public company without trying to gain control.” – In its essence, shareholder activism is more inclined to correct core business discrepancies before the market reads any sign of trouble via share volatility.
  • Value investors such as Warren Buffett are lauded in the industry while activist investors such as Carl Icahn and the Vanguard Group are called out for short-termism. However, Sharfman clarifies that while value investors cannot practice activism based on their own long holding period strategies. In reverse, activist funds impede their own shareholder wealth creation if they have long holding periods, since their strategies are based on intervention.
  • Since most activist fund strategies are based on intervention, activist investors can be viewed as financial engineers that can offer very timely and effective financial restructuring advice to a Board. Such advice may not come from executive management caught in day to day operations and so may not have an adequate view of the broad financial picture. It sounds humbling, but in reality it may work to a company’s advantage to have a short-termism in financial engineering from an actual shareholder.
  • The threat of a proxy contest may be the most important weapon the activist hedge fund has in its arsenal to effect change. While activist investors have become notorious for proxy contests, the authors found that only 13% of hedge fund activism resulted in proxy contests. Thus, the simple idea of a proxy contest may be enough to spark strategy change at the Board level.
  • The Board of Directors must have a strong outside director composition to allow investor activism to work in a positive fashion for long term company performance. A non-executive director stronghold on a public board gives the Board more authority to listen to both the dictates of activist investors and executive management, and so allows broader decision making for company strategic direction.

Consider activist investors as the best devil’s advocate. A company can hire an independent consultant to assist the Board in setting strategic direction; however, an activist investor literally has more to lose with company profit at stake! And these investors are the savviest investors in the industry – as bullying as their tactics may seem, they are top financial engineers that can truly structure profitable companies. Many companies are embracing the activist investor style of C-Suite leadership. The Vanguard CEO William McNabb has advocated forming a “Shareholder-Director Exchange” to have clearer communication between activist investors and Boards, to facilitate such financial engineering and prevent negative market reads in a proactive manner. Former Texaco CEO and Director of Abbot Laboratories Glenn Tilton further encourages public boards to be one step ahead of shareholder activists in terms of strategy and risk management expertise. Prevention is better than cure.

Carl Icahn has defended his position as activist investor, saying “I look at companies as businesses, while Wall Street analysts look for quarterly earnings performance. I buy assets and potential productivity. Wall Street buys earnings, so they miss a lot of things that I see in certain situations.” Activist investors challenge companies’ core competencies. However, they challenge Wall Street’s investing myopia as well. Devil’s advocates they may be, yet the activist investor may well be the true change catalyst for practical, no frills, efficient corporate governance.

Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.

Harvard Business Review. 2015. “Your Board Should Think Like Activists.”

Sharfman, Bernard S. 2015 “Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value.” Columbia Business Law Review. Pages 103-139.

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US Infrastructure Development: A Case for Public Private Partnerships

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A nation is nothing without infrastructure. It is the literal blueprint which allows education, healthcare, commerce and trade to expand and progress within rural and urban areas alike. A country is identified and remembered by its most outstanding infrastructure, from longstanding historic monuments to major highways. Thus, it goes without saying that it must be primary business of federal, state and municipal governments to maintain replenish and expand physical infrastructure to ensure continued growth and communications.

Physical infrastructure within the US has historically been built on thorough, systematic urban and rural planning. As with most countries, new infrastructure projects tend to burgeon in the form of government centers, parks and recreation facilities and monuments based on the promises of newly incumbent regimes. However, basic infrastructure maintenance, specifically maintenance of roads, highways, commercial maritime ports, public schools, and public hospitals, are in need of redress. The maintenance of basic infrastructure, while not as glamorous as a new monument, is vastly essential. However, US fiscal policy towards infrastructure has fallen well over the past twenty years. While certain states and municipalities have an airtight dedication to capital improvements, overall less public investment has gone towards a basic infrastructure need. This is mindboggling. Basic infrastructure growth and maintenance is what differentiates developed nations from emerging counterparts.

The federal government has time and again stated that public funds are not adequate and forthcoming to manage the vast gamut of capital improvement needed. Yet, infrastructure maintenance is a must. Therefore we turn to the most viable alternative for capital improvement, the public private partnership (PPP). A PPP in its traditional sense represents a working, project-based agreement by which private firms partner with governments on public projects, providing either or both the building expertise, private capital investment and operating cost coverage for the project with the expectation of project revenue until a definite date. Past the aforementioned date, the finished, fully operating project is then returned to the public entity, and is then placed on public books as an asset/liability.

The PPP in the traditional sense has worked extremely well for new, short term infrastructure projects. Governments tend to be very flexible in funding allowance when it comes to new projects. However, in longer term transportation maintenance projects, even PPP built projects can lead to excessive costs to both the government and the private firms involved. PPPs used for new projects need to be structured differently from PPPs used for building retrofit or highway capital improvements in terms of project dictates and contract stipulations. It is very important to note that a PPP does not immediately guard against wasteful fiscal policy on the part of government. All PPP projects need cost-benefit analysis from the planning phase of the project, with input from both private and public sector teams. Taxpayer funds are too often mismanaged under the guise of capital improvements, and an effective PPP should seek to avoid such wastage of public funds.

Eduardo Engel, Ronald Fischer, and Alexander Galetovic of The Brookings Institution’s Hamilton Project have conducted an extensive study on PPPs’ effectiveness in both project and policy effectiveness on an international basis, with specific recommendations geared to US public policymakers. They found that the US has by and large developed policy to depend mainly on public funds for capital improvements in transportation. They also found that PPPs to date have been less successful than hoped for due to post-bid contract renegotiations. Post-bid renegotiations may allow for insider fund allocation, and may leave room for political lobbying and even kickbacks. Capital improvements are sunk costs, yet necessary and crucial. Therefore, we must develop our PPP structures to grow and maintain infrastructure in the most efficient ways possible. The Brookings Institution proposes many viable recommendations and suggestions to ensure effective PPP utilization.

The most pertinent, that in our opinion may yield the highest return on effort and investment, are as follows:

  • The projects [must all be] treated in the government balance sheet as if they were public investments. – This point allows for transparent tax use policy, even if the project future value is included in accounting footnotes during the leasing period of a PPP.
  • The internal structure of the public works authority (PWA) of state and local governments should be split between a unit responsible for planning, project selection, and awarding projects, and an independent unit responsible for contract enforcement and the supervision of contract renegotiations.
  • A strong argument for the PPP over traditional [build-only] provision is that the concessionaire internalizes life-cycle costs during the building phase. To the extent that investments during the building phase can lower maintenance and operations costs, efficiency gains should result.
  • Encouraging the private sector to generate innovative ideas can have merit…This requires the development of mechanisms for compensating the private parties for their ideas without affecting the transparency and efficiency of existing PPP awards.
  • PPPs often have beneficial distributional impact when they involve new infrastructure or a major improvement of existing infrastructure, as long as they are financed with user fees [e.g. toll roads], since those who do not use the project do not pay for it but may benefit from less congestion on free alternatives.
  • Some states, including Florida and Indiana, require legislative approval of PPP projects after the concessionaire has been selected [causing renegotiation conflicts of interest]. Award the project to the firm that asks for the smallest accumulated user fee revenue in discounted value, or the Present-Value-of-Revenue (PVR). This type of contract would compensate for the risk—and risk premium—by tying the length of the concession to [user] demand for the project.
  • PPPs will not filter [economically unprofitable] projects out if they are financed with subsidies or if there is an implicit guarantee that the government will bail out a troubled concessionaire. – In this instance it is pivotal to utilize cost-benefit analyses for all projects undertaken from the inception to planning stages.

The Brookings Institution points out that many traditional build-only and hybrid private sector infrastructure partnerships do not work effectively due to reactionary bureaucratic red tape. It is highly recommended to have public private partnership dictates be encapsulated in local and state ordinances. Legal enforcement on the local level for infrastructure undertakings may be the best remedy to combat bureaucratic hurdles.

The United States has lagged behind the United Kingdom and Canada both in terms of the development of and the effectiveness of public private partnerships, which is surprising, since the US private sector is stalwart. Again, PPPs refer not only to contract-build-release, which consists of the public sector employing private firms; this is common practice. Authentic PPP development is based on build-operate-release on the part of the private concessionaire. Canada has the most positive trend in successfully managing public private partnerships. Indeed, British Colombia has such a high success rate of infrastructure capital improvement completion, they have to date encountered the problem of completing project timeline in record early time. We personally are pleasantly astounded by the thought of having policy and practicality working so harmoniously!

Apparently, British Columbia and the Canadian Government in general have followed The Brookings Institution’s recommendation above concerning having a separate, business driven department within the public works authority (PWA) solely responsible for contract development, enforcement, supervision and completion of PPPs, or P3s as they are known in industry-speak. This internal separation of duties within public works is akin to a project management office or PMO, with added policy authority. It is refreshing to see tax utilization be so efficient, thus bolstering proper fiscal policy. The US has over the past decade created the Build America Transportation Center to foster and encourage PPPs within transportation infrastructure development, which is a step towards capital improvement. However, on the state and local level the US has yet to employ dedicated offices that deal with PPP development and monitoring on the ground level. We need to address this.

The US Government to date is struggling to find funding for capital improvement and development, and it shows. Urban centers, major highways in states without strong fiscal backing and without strong private investment are showing significant signs of overuse and under care. More important than the visual, is the utilization. Commerce, education, and healthcare are strongly affected by infrastructure incapacity. In a climate which is calling for expanded expertise and increased domestic and international trade, can we really afford to have our infrastructure crumble? We hope that from a federal to local level, the US may employ effective use of public private partnerships in capital improvement to support continued economic development and progress.

Sources:

Engel et al. 2011. “Public-Private Partnerships to Revamp U.S. Infrastructure.” The Hamilton Project. The Brookings Institution. Pgs. 11 – 22.

Governing The States And Localities. 2013. “Why Isn’t the U.S. Better at Public-Private Partnerships?” http://www.governing.com/topics/finance/gov-public-private-partnerships-in-america.html

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