Short Squeeze
Alpha - 06/19/03
Justin Schack
New SEC chairman Bill Donaldson is accelerating the agency's investigation of hedge funds, making tighter regulation all but certain. How far will he go?
It's not easy being a financial market regulator. In the three years since the biggest speculative bubble in history exploded, a litany of nefarious practices that helped pump it up has steadily, painfully come to light. Tainted stock research. Fraudulent accounting. Boardroom bosses treating public companies like private piggy banks. Too often, regulators were embarrassingly late to address conduct that, checked earlier, might have eased the pain for investors. Their tardiness cost them credibility and, in the case of former Securities and Exchange Commission chairman Harvey Pitt, a job.
Public watchdogs aren't likely to make the same mistake with hedge funds. These private partnerships have become too aggressive, too high profile and too flush with money to ignore. Hedge funds are sprouting like fairy-tale beanstalks. Nearly 6,000 manage some $600 billion today, up from $50 billion as recently as 1990. In the first quarter of 2003, according to hedge fund consulting firm LJH Global Investments, investors funneled $1.4 billion into hedge funds, even as $11.2 billion was being yanked from equity mutual funds.
Such explosive growth makes people nervous. Amid the spate of recent scandals, no one wants to get caught napping while another bubble inflates and then bursts, especially as hedge fund firms increasingly offer their wares to retail clients.
While politicians like Democratic Senator Paul Sarbanes of Maryland fret about "a ticking time bomb," the cops on the beat are clamping down -- holding hearings, conducting investigations, stepping up the pace of prosecutions. It's handy politics, too: With average American investors reeling, who better to beat up on than Wall Street's latest crop of multimillionaires?
As the nation's chief financial markets overseer, the SEC is leading the crackdown. It has spent the past year interviewing dozens of hedge fund managers, scrutinizing how the industry works as part of a fact-finding investigation. The agency is looking into what it calls the "retailization" of hedge funds, which traditionally have been limited to the wealthy and institutional investors, as firms launch funds of funds and other structured products more available to the masses. It wants to determine whether a lack of disclosure about holdings and returns encourages managers to commit fraud. The SEC is also considering whether strategies and tactics used by hedge funds, such as short-selling, have a destabilizing effect on the capital markets.
The probe was begun by Pitt but never considered a top priority during his tenure. New SEC chairman William Donaldson, all too aware that his agency has been criticized for acting belatedly on Wall Street and corporate scandals, has moved it to the top of his to-do list. He is eager to make the agency more proactive and concerned about whether hedge funds pose a systemic risk. "We need to know more about hedge funds before something bad happens," he tells Institutional Investor's Alpha, in an in-depth interview (see Q&A, at left). "Look at what happened with Long-Term Capital Management back in 1998. We have to ask: Are hedge funds doing things that disrupt or distort the market for public investors?"
Though few observers expect the probe to yield sweeping new regulations, some measures being considered would bring significant changes to the industry, such as requiring all funds to register as investment advisers and open their books to SEC examiners. The minimum income and asset levels required of hedge fund investors are likely to be raised, inhibiting managers' ability to market retail-oriented products. Placing some limits on short-selling is not out of the question. Says Donaldson, "It's not the short-selling itself but how it's done and who's doing it that have the potential to raise some concerns."
Despite considerable fear of the potential costs and unintended consequences of tighter regulation, some hedge fund managers nevertheless find cause for optimism. "The SEC is conducting itself in a very thoughtful and very responsible manner," says Leon Metzger, vice chairman of Greenwich, Connecticut_based hedge fund group Paloma Partners Management Co. Metzger doubts that additional regulation will deter those intent on committing fraud, but he's convinced that the SEC aims first to do no harm and that the extra scrutiny will benefit all honest hedge funds. "Only good things can happen from this," he says.
Although not entirely unregulated, most hedge funds either are based offshore or operate under a series of exemptions from U.S. securities laws. This allows them to avoid much of the extensive disclosure, trading restrictions and compliance examinations imposed upon other money managers by the SEC. Some of the biggest are registered as investment advisers because certain institutions are unable to commit capital to funds that are not. But the vast majority remain unregistered -- and off-limits to SEC examiners.
Hedge funds have had their share of scandals. The near collapse of Long-Term Capital Management, that collection of übertraders and Nobel laureates, nearly brought down the global financial system in 1998. Wall Street bailed out LTCM, and the hedge fund industry successfully dodged tighter regulation.
More recently, however, hedge fund investors have been beset by fraud and mismanagement. In late 2000 the SEC and the Department of Justice charged Michael Smirlock, former CEO of Laser Advisers, with overstating the value of Laser's portfolios and concealing losses of more than $70 million. Smirlock last year settled the SEC complaint and pleaded guilty to criminal charges. He was sentenced to four years in prison. Also in 2000, Manhattan Investment Fund manager Michael Berger admitted to hiding more than $400 million in losses from investors.
The list goes on: Kenneth Lipper, a former film producer and New York deputy mayor, faces a raft of lawsuits from his A-list investors, who last year learned that his firm, Lipper & Co., had inflated the value of its convertible-arbitrage fund for six years and collected performance fees based on the overstated asset levels. Within the past year blowups at funds like Beacon Hill Asset Management and Japanese hedge fund Eifuku have resulted in hundreds of millions in investor losses. Beacon Hill is accused by the SEC of failing to fully disclose losses of $400 million.
Particularly disturbing to regulators, in light of the fraud and internal controls issues, is the rise of products that are being offered to retail investors in amounts as low as $25,000. The SEC approved the first such vehicle last summer. Since then 17 more have been formed.
The SEC is not alone in its inquiries. The National Association of Securities Dealers, which oversees the brokerage industry, warned its members in January to strictly observe customer suitability rules when marketing hedge fund products. In April it levied a $175,000 fine against Altegris Investments, a La Jolla, California, brokerage, for failing to disclose the risks of the hedge funds it marketed to investors.
The Senate Finance Committee is probing investors' use of offshore hedge fund accounts to dodge U.S. income taxes and hide corporate profits. In April the Senate Banking Committee held a well-attended hearing on hedge funds, in which senators grilled Donaldson about the progress of the SEC's investigation. A House subcommittee on capital markets quickly followed suit. Even Bermuda, home to many offshore funds, is considering amending its regulations to foster greater transparency for hedge funds.
BEFORE DONALDSON TOOK OFFICE in late February, the SEC's hedge fund investigation had languished. Pitt announced the study last spring, almost as an afterthought, at the end of a wide-ranging speech to the Investment Company Institute. At the time, he was preoccupied with other concerns -- chiefly, fighting for his job. Pitt intended a limited inquiry, focused on collecting information about a narrow range of issues, such as fraud and marketing to retail.
Donaldson has breathed new life into the probe. The new chairman brings to his office a broad perspective when it comes to hedge funds. He co-founded Donaldson, Lufkin & Jenrette, the first modern Wall Street research boutique, during the hedge fund industry's infancy and counted many of them as clients. As CEO of embattled health insurer Aetna in 2000 and 2001, he was dogged by activist hedge funds. Several, most notably Leon Cooperman's Omega Advisors, were among the Aetna shareholders that pressured Donaldson to quickly boost the company's stock price as he attempted to engineer a longer-term turnaround (Institutional Investor, July 2000).
Hedge fund industry officials who have been in contact with the agency as part of its study notice a difference since Donaldson took over. "Their agenda has changed, and their focus has changed," says LJH president James Hedges. "At first they wanted basic information, and they were concerned about fraud. Now they're beginning to drill down on much more substantive issues, like operational risk and compliance, the pricing of portfolios, marking positions to market, disclosure to clients, as well as business structure and internal controls."
The probe is expected to be complete by midsummer, at which point the SEC will discuss its findings with other regulators and issue a public report before proceeding with any specific proposals. Donaldson won't tip his hand, but SEC staffers and people who have been in contact with them say that the agency is likely to require all hedge funds to register as investment advisers, which would subject them to the same recordkeeping and inspections program as the country's more than 8,000 mutual funds. Currently, only about one third of hedge funds register on a voluntary basis. Being able to examine hedge funds' books and records, SEC officials say, will enable them to detect problems like valuation discrepancies and hidden losses before they become major, potentially systemic, events.
This would also mean added administrative and legal costs, and some doubt whether those burdens are justified. Companies like Enron Corp. and WorldCom allegedly committed accounting fraud despite having to file certified financial statements with the SEC, they argue. Additionally, critics point out that the long-understaffed SEC only has enough resources now to inspect mutual funds once every five years. Even with budget increases pending, the agency may be stretched further by adding thousands of hedge funds to its inspections roster. What's more, some 2,600 hedge funds are already registered with the Commodity Futures Trading Commission, which inspects these firms once every three years. Although CFTC examiners aren't looking for violations of securities laws, as SEC staff would, critics still argue that SEC registration would be duplicative.
"If I were at the SEC, I'd be looking at what real, practical good registration does," says Jack Gaine, president of the Managed Funds Association, a hedge fund lobbying group based in Washington, D.C. "Is there a way to do some background screening to determine the cost versus the risk in any one fund and how much additional protection there would be from inspecting them?" Adds Kenneth Raisler, head of the commodities, futures and derivatives group at law firm Sullivan & Cromwell: "The question is, would inspecting all 6,000 hedge funds take away from looking at the mutual funds that are dealing with the retail customer exclusively? I have a little trouble with that. We believe that government resources should not be spent protecting sophisticated investors."
The SEC may also update the various criteria that govern who can invest in hedge funds. The most commonly applied standard in this area restricts the purchase of hedge fund shares to "accredited investors" -- defined as individuals with at least $200,000 in annual income ($300,000 with a spouse) or a minimum of $1 million in investable assets. These criteria were established in 1982, and many experts consider them outdated given the significant growth of assets and incomes since then. "They should probably be doubled," said Douglas Scheidt, deputy director of the SEC's Division of Investment Management, during a public roundtable the agency held last month to discuss hedge fund regulation. But because they also apply to private investment partnerships that are not hedge funds -- such as venture capital, leveraged buyout and real estate funds -- bringing them into the 21st century will likely occur separately from any hedge-fund-specific rulemaking.
Another big worry for regulators -- and investors -- is the vast wiggle room hedge funds have in valuing illiquid securities in their portfolios. Funds may buy lightly traded convertible bonds, distressed debt, derivatives and other exotic instruments, for example, based on sophisticated financial models that show these assets trading at substantial discounts to their intrinsic values. Funds may be tempted to carry these investments on their books at their projected higher values rather than at their market values, a practice that can conceal big losses if managers' bets don't pan out as planned. Pension funds and other sophisticated investors increasingly are addressing this issue by demanding to see audits and performing other due diligence before forking over their cash. But regulators remain concerned.
"In my opinion more disclosure is needed," Mark Anson, chief investment officer at the nation's largest pension fund, the $131 billion-in-assets California Public Employees' Retirement System, told SEC staff and commissioners during last month's roundtable. Because of intense demand for the best funds, which are often closed to new investors, and because hedge funds hire the best legal representation money can buy, Anson said, "the power right now lies with hedge fund managers" when it comes to disclosure and the terms of partnership agreements.
One possibility is that the SEC might mandate that hedge funds employ outside auditors to sign off on their valuation methods in filings to the agency. It may also require that hedge funds disclose more about the nature of their holdings and their performance. Opposition to both moves is likely to be stronger than to mandating registration and raising investment thresholds, however.
A broader area of concern that could yield new regulation relates to the market impact of hedge funds -- how their trading strategies affect corporate issuers of securities and the other investors who buy and sell them. Specifically, Donaldson and others at the SEC are examining whether selling stocks short, which is essential to most hedge funds' strategies, is hurting companies -- as well as other investors who are restricted from short-selling.
Many companies have complained that short-sellers act in concert -- by communicating on Internet chat boards, publishing "research" reports and even planting negative stories in the press -- to drive down share prices. (To be sure, some studies have shown that the companies that complain the loudest about short-sellers are the worst underperformers over time, meaning that the shorts are right more often than not.) The SEC is also examining whether the rapid-fire, computerized trading strategies practiced by many hedge funds compromise the ability of other investors to efficiently buy and sell securities.
It's too soon to tell what action the agency may take in this area. SEC commissioner Roel Campos suggested in early February that short-selling should be restricted in some form. A more likely possibility is requiring hedge funds to disclose, in some fashion, their short positions. The loosely constructed yet increasingly powerful hedge fund lobby will fight any such proposal vigorously, believing that the ability of hedge funds to execute their sophisticated strategies without detailed public disclosure is the essence of what allows them to generate such impressive returns. Disclosing short positions would trigger gaming by competitors, who would use the information to trade against the largest funds, potentially yielding huge losses for investors, they argue (see "Sound Off," Alpha page 8).
Another intriguing move that the SEC might make: loosening the restrictions that keep mutual funds from using the same strategies as hedge funds. By the end of the two-day SEC roundtable last month, commissioners and staff appeared to be considering just that, thinking that the ordinary investors who lost hundreds of billions in long-only mutual funds during the past three years might have benefited from the absolute-return strategies of hedge funds.
Donaldson keenly wants to make sure hedge funds are overseen properly, but he will tread carefully. "We don't want to be sitting up here in an ivory tower and making regulations that might do more harm than good," he says.
That has reassured many in the hedge world. A thorough inquest, followed by sensible measures that hedge funds can adopt to protect investors without compromising their returns, could provide a sort of Good Housekeeping seal for the industry. Investors who remain wary of hedge funds because of their Wild West reputation and the string of scandals in recent years may come to view them with a new legitimacy.
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