On November 19, 2009, Brad Sherman, a Democratic congressman from California, shocked the hedge fund industry. In an amendment proposed to the financial reform bill that the House of Representatives was considering, Sherman added large hedge funds to the group of financial institutions that would have to pay into a so-called Systemic Dissolution Fund to help dismantle failing financial companies and thus avoid more taxpayer bailouts.
Overnight, it appeared that hedge funds with $10 billion or more in assets under management would have to pay into the $50 billion fund. “The hedge fund industry was really caught off guard,” says Andrew Lewin, a principal at the Podesta Group, which has lobbied on behalf of hedge funds like Fortress Investment Group. “It came out of left field. They didn’t understand why Sherman singled them out; they didn’t understand why it moved so quickly through the markup process.”
But just because Sherman’s move was unexpected didn’t mean hedge funds were unprepared. Hedge funds and their lobbyists moved quickly, meeting in December with members of the House and Senate to see if the Sherman amendment—which would have affected the roughly 35 hedge funds that fit the criteria—could actually pass.
Simultaneously, the Managed Funds Association, the industry’s voice in Washington, sent a scathing letter on the resolution fund to Congressman Barney Frank (D-Mass.), chairman of the House Financial Services Committee. “We are extremely troubled by the punitive hedge fund ‘carve in’ language,” wrote MFA president Richard Baker on December 1, referring to the inclusion of hedge funds in the group to contribute to the fund. “The bill now perversely singles out hedge funds for more onerous treatment without any articulated policy rationale.”
The hedge fund language was never stripped from the amendment, but the industry’s lobbying efforts, as well as Republican opposition to a fund in general, appear to have killed the idea. And as financial reform gained traction this year—boosted by Democratic resolve to toughen the rules—hedge funds started giving more money to Republicans for the first time in years.
Hedge fund lobbying on financial reform hasn’t prevented new oversight of the industry. Mandatory registration of larger funds is a given; exchange-trading for derivatives might increase their cost, and large hedge funds were facing the possibility they could find themselves deemed “systemically risky,” which could hamper their activities.
However, several years of communication with lawmakers is paying dividends. Hedge funds have been largely shielded from proposals that single them out, and the industry has avoided the strong controls likely to be placed on banks.
“It’s been years of patient work of substance, of data, of letting members, staff and policymakers touch, feel, poke and prod while the sun was shining,” says Andrew Lowenthal, managing director of the Coalition of Private Investment Companies, a group formed in 2005 by James Chanos of Kynikos Associates. “When the tsunami came, there was a sense of comfort that they understood where hedge funds fit.”
That wasn’t always the case. Mandatory registration was imposed on hedge funds by the Securities and Exchange Commission in 2005 despite the MFA’s opposition. Although the MFA wasn’t involved in the suit against the SEC’s rule, the lobbying group was overjoyed that the rule was overturned by the courts within months of its being enacted. But the joy was temporary.
“The industry won the regulatory battle but lost the public relations war,” says Eric Vincent, president of Ospraie Management and the member of the MFA board who, as chairman, helped change the culture of the group. “The perception in Washington was that the industry dug its heels in and wasn’t willing to work with lawmakers—that it was arrogant and stubborn.”
Vincent adds that the MFA “became less of a fortress-type organization trying to protect the industry and more an organization that was looking to reach out to Washington and better explain who we were.” He also went on a membership drive, creating a founder’s council with dues of $225,000 per year; it now has 20 members and a waiting list. A heftier budget has led to an increase in lobbying dollars spent—$3.78 million in 2009 and $1.37 million through April 2010—enabling the MFA to hire some big names in Washington, including Roger Hollingsworth, a former staffer on the Senate Committee on Banking, Housing and Urban Affairs, and Carmencita Whonder, who worked for New York Senator Charles Schumer and now lobbies for MFA at law firm Brownstein Hyatt Farber Schreck. MFA president Baker, a former Louisiana Republican congressman, also knows how to work the aisles.
For some consumer advocates, that change in political influence has been all too effective. “The shadow banking system is going to remain in the shadows,” says Robert Weissman, president of consumer advocacy group Public Citizen. “The hedge fund insiders have shown that they know how to effectively operate inside Washington as well as inside trading markets.” Weissman calls hedge funds “institutions of the casino economy,” and thinks financial reform legislation should include public disclosure of information, mandatory limits on leverage and better oversight of the industry’s role in systemic risk.
Others defend the industry’s Washington outreach. “They’re not doing anything out of the ordinary for what all other stakeholders are doing, and they’re not getting any special treatment,” says one prominent hedge fund lobbyist. Indeed, hedge fund political contributions are relatively small compared with those of the rest of the financial industry. The hedge fund industry spent $6.6 million lobbying in 2009, but commercial banks spent $50.6 million the same year, according to the Center for Responsive Politics.
This lobbyist—an ex-Senate staffer—concedes that the hedge fund industry enjoys relatively good access to lawmakers and constructive relationships with them. But the person says that the industry has made a legitimate case to differentiate hedge funds from other systemically risky financial institutions. “They haven’t been just out there blocking things left and right.”
A senior House Democratic staffer says they’ve seen engagement by the MFA and individual hedge funds like Citadel Investment Group, especially on derivatives, but notes the industry’s well-connected lobbyists aren’t the reason hedge funds have avoided more restrictions. The legislation, the staffer says, has always been about the banks, because they created the financial crisis—and because their products are sold to average consumers. “There hasn’t been as much ire focused on the industry as there has been on other aspects of the financial services sector,” he says.
The lobbying influence debate aside, three new sets of rules in the legislation will directly affect hedge funds: registration, systemic risk oversight and derivatives.
Mandatory registration of investment advisers is the part of the legislation that will most affect hedge funds, but it was widely expected and endorsed. In a reversal, the MFA came out in support of registration in May 2009, following the assurance that additional disclosure on issues such as short sales and leverage will be made to regulators and not to the public.
“The comprehensive disclosure and compliance requirements would include publicly available disclosure to the SEC regarding key aspects of the adviser’s business, extensive systemic-risk reporting to the SEC, detailed disclosure to clients, policies and procedures to prevent insider trading, maintaining extensive books and records, and periodic inspections and examinations by SEC staff,” the MFA confirms in a statement.
In practice, registration means important changes like maintaining daily records of trading activity, hiring powerful chief compliance officers, producing thick compliance manuals and even periodic visits by SEC staffers to check records. Information about specific firms will be kept private, but public reports on the industry as a whole could be released.
Those new rules could be expensive. Industry insiders estimate registration compliance will likely cost hedge funds between several hundred thousand dollars to millions of dollars a year each. Just implementing the new rules would likely take up to six months (hedge funds would probably have a year from when the legislation is signed).
Senator Jack Reed (D-R.I.) recently introduced an amendment that would require hedge funds under the SEC reporting threshold (likely $100 million) to either be registered and examined by a state regulator or registered with the SEC. If approved, all hedge funds would face some sort of registration and examination.
The majority of the industry’s largest and most influential hedge funds already register, so the battle was really over how invasive—and public—registration would be. As a result, some think registration doesn’t go far enough. Heather Slavkin, a senior legal and policy adviser for the AFL-CIO Office of Investment, says many of the new transparency rules, while a step forward, won’t do a lot more to protect investors and are already standard for other large businesses. Slavkin thinks that capital and liquidity requirements should have been included in the bill.
Another aspect of the legislation that could affect the largest hedge funds is the creation of the Financial Stability Oversight Council, the systemic-risk watchdog. Members of the council could technically deem a hedge fund systemically risky and thereby recommend restrictions on its activity to the Federal Reserve Board and even, as a last resort, the sale of some holdings.
“Hedge funds are on the hook for supplying more information down the road if regulators want it. As long as that provision is in the bill, that’s all we need,” says Robert Litan, vice president for research and policy at the Kauffman Foundation, a charity devoted to entrepreneurship. “The oversight council will be a free safety and they can get what they want.”
Regulators will have the authority to request information on such things as leverage, long and short exposures, derivatives, and counterparties, all of which the MFA has endorsed. “I think it might be good for the industry if there was a little more transparency and policymakers better understood our business,” says Darcy Bradbury, the chairman of the MFA and a managing director of D.E. Shaw.
The AFL-CIO’s Slavkin adds that the new systemic-risk regulator will theoretically have oversight of large hedge funds, but its efforts will likely be too little too late. “By the time it’s apparent, it’s a problem,” she says. “The notion that the systemic-risk regulator is going to be out there saying, ‘Oh, you’re a problem, now you’re regulated, now you’re fixed,’ seems sort of silly to me.”
On the other hand, new rules on derivatives are one of the biggest issues for hedge funds—and a big source of lobbying time and effort. The specifics were still being debated at press time, but it’s anticipated that most liquid over-the-counter derivatives will be centrally cleared or traded on exchanges, and large hedge funds who trade significant amounts of them will be considered “major swap participants,” the exact definition of which could be decided at the regulatory level.
Regardless, it’s a designation that has impact. Lawmakers crafted the laws to avoid a repeat of AIG’s derivatives-tied implosion; the new business conduct rules and capital and margin requirements are meant to mirror how bank dealers are regulated. Additional margin and collateral requirements might increase the cost of trading derivatives in the short term, but some hedge fund managers view trading derivatives on exchanges as positive with longer-term cost benefits.
“You have better clarity in terms of what the market is, and you only worry about the creditworthiness of the counterparty,” says the manager of a multibillion-dollar hedge fund who supports the bulk of the financial reform legislation. “It’s a far better system.”
Hedge funds wanted to have a clearinghouse and margin requirements for the bank dealers, who are their counterparties, as well as margin segregation to split customer collateral from that of the dealer. “Some of the larger brand-name funds were very effective in their advocacy,” says a financial services lobbyist and former Senate staffer who has worked with hedge funds. “It may have not been seen as the most altruistic of advocacy moves, but it certainly resonated with certain policymakers.”
The Senate banking committee was briefed by managers from some of the biggest hedge funds, and the access to lawmakers on the derivatives issue was so good, the former staffer says, that some large banks were “exceedingly displeased” knowing they could lose business to them if their swap desks were spun out, a proposal that was included in the May 20 Senate bill. However, some hedge fund executives criticized the proposal, saying that it might make these counterparties less regulated and capitalized, which is the opposite of what’s intended with reform.
In recent months, a new proposal in the Senate bill caught hedge funds off guard—and seemed to illustrate the need for constant vigilance as the technical details of the legislation were ironed out. As first reported by AR online, this proposal could hurt funds that invest in distressed debt by giving the Federal Deposit Insurance Corporation wide latitude in determining how to treat what it terms “similarly situated creditors” when a financial institution fails. The provision was later tweaked to make it less worrisome to hedge funds.
That proposal is an indication of how regulation of broad, relatively undefined mandates in the legislation could affect hedge funds in the future. “The things that zap you or that catch you unaware are typically the ones that happen without a big story in the press,” says Daniel Ripp, president of Bradley Woods & Co., a political research firm that services “brand-name” hedge fund clients. “They’re things that are happening quietly at some agency long after the statute has been written and passed.”
For example, a rule could be written based on the financial reform bill as quickly as the end of this year that could limit the credit that banks can extend to hedge funds.
So regardless of what President Obama signs into law, hedge funds won’t be leaving Washington anytime soon. Shortly after the Sherman amendment was proposed late last year, several hedge fund managers met with a U.S. senator considered a moderate Democrat who sits on the banking committee, according to a lobbyist familiar with the briefing.
The managers walked the senator through why they believed the language was unfair to the industry. Hedge funds weren’t overly leveraged or systemically risky and didn’t cause the financial crisis, they pointed out.
The senator took in the talking points, thought for a moment and then looked at the hedge fund managers across from him. “Well, you make a good point,” he said. “But you know, guys—you weren’t responsible for the last crisis, but you’ll probably be responsible for the next one.”
