Business: Hedge Fund Regulation

Washington Post business columnist Steven Pearlstein was online to discuss recent scandals in the hedge fund industry a call for for government regulation.

In today's column , he writes that hedge funds, at a minimum, should be required to send audited, quarterly statements to investors and the SEC.

A transcript follows.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here .

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Ithaca, NY: Steven -

I'm afraid you're quite wrong in your analysis of the hedge fund market. The facts do not back up your assertion that it is "littered with charlatans". Furthermore, you'd have a hard time making the case that more regulation leads to better action on the part of the regulated. Look at the mutual fund scandal. Recent hedge fund scandals have involved managers who ran relatively small amounts of money for sophisticated investors putting management's interests ahead of shareholders. The mutual fund industry, far far far more regulated - they can't go to the bathroom with out a hall pass from the SEC - saw some of the largest fund complexes in the country, running hundreds of billions of dollars of investments for unsophisticated retail investors, putting their own interests first. Regulation didn't stop the bad guys there, why do you think more regulation in the hedge fund industry will do anything more than add complexity and costs without commensurate protections?

And... protections for whom? The qualified purchasor rule already means that investors have to be well off or decent-sized institutions, and all the offering memoranda lay out the riskyness of the investments. Institutions have an obligation to themselves to do some basic diligence, and anyone who had done so on Bayou would have known to run for the hills. Bayou, do you have an auditor? Ok, who is your auditor? Hmm, that's odd, never heard of them and there aren't that many firms that audit hedge funds. Who is this firm? Oh, it's a one man shop made up of the CFO of Bayou?

If organizations like the Jewish Federation of Chicago would rather not ask those basic questions up front and instead spend their time in the legal system later to get some level of asset recovery, that's their choice. It's up to their board and their governance to set that policy, and that's as it should be.

Steven Pearlstein: That's all very interesting. But you cannot site one reason why requiring audited statements will somehow negatively impact the activities of honest and well run hedge funds. And the implication of your argument is that investors would be better if there were no SEC, CFTC, Accounting Oversight Board, which is well outside the mainstream thought of most people who have thought about this.

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Glen Echo, MD: Eddie Lampert's ESL fund has made much more than 10x for investors on its investment in KMart (including the subsequent takeover of Sears). Sure, neither you nor I might have enjoyed shopping at KMart or Sears recently, but it's both the beginning of a good turnaround story as well as an instance of hedge funds being able to unlock the hidden value of an asset. And what's wrong with that? Sure, Lampert has made a huuuuge amount of money. But I challenge you to find one investor in ESL that thinks he hasn't earned it. On a net of fees basis, investors in ESL have done extremely well.

Your portrayal of Lampert in your column is simply not factual at all, and shows that you made no attempt to glean the facts of the situation. Rather, you used him to help grind your axe. The Post and the Post's readers deserve better than that.

Steven Pearlstein: Eddie Lampert has not turned around Sears and K-Mart, just as he did not turn around Auto Zone for the long run. He cut costs, reduced service, disinvested and got a few good years of operating results out of it. And why should we be surprised. He is not an experienced operator -- he's a financial engineer, and a damn good one. But that's all. One of the problems is that these guys think that because they are good at one thing, they are smarter than everyone else and can anything. And they usually can't.

Obviously Eddie Lampert's investors think he is worth a billion bucks a year, for if they didn't, they would pull their money out. I only mention it because the pattern is that you know when the bubble is about to burst when the executive compensation rises to ridiculous, astronomical levels. And a billion dollars a year surely qualifies. I'd also say that it has an effect on the pay expectation of other people, and becomes a part of the unfortunately dynamic of escalating executive pay throughout the system, which I consider a bad thing from a moral as well as an economic point of view.

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Danvers, Mass.: There once was a boy from Omaha who went to NYC to work for an old guy and learn a few good ideas about investing. By age 24 he had secured his own retirement and went home. Not knowing what else to do, he organized a partnership among family and friends who were not already wealthy which resembled what the old guy in NYC was doing. Today it would be called a hedge fund. Today his original investors are spectacularly wealthy and the boy has grown into a man widely regarded as a paragon of business virtue. Even management of the Post owes him for substantial influence leading to good decision making. It would seem whatever regulation there is should not cut off the chance of another Warren Buffett in this world.

Steven Pearlstein: Warren Buffett doesn't pay himself a billion dollars a year. And his track record is fabulous in buying companies for a good price, holding them, encouraging management to run good companies. Eddie Lampert may fancy himself as the next Warren Buffett but he's got a long way to go to prove it. He's not even a Wilbur Ross. So far, all he is a Wall Street sharpie along the lines of Carl Icahn.

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Arlington, Va.: former hedge fund manager was online earlier this month to discuss his book. He said regulation almost always backfires. "Reg FD, Fair Disclosure, was supposed to help the little guy by making all disclosures as broad as possible. But it turned into Reg ND, for NO DISCLOSURE, because companies are so afraid of saying the wrong thing at the wrong time and getting sued. (See Seibel)."

What do you think?

washingtonpost.com: Discussion Transcript : Andy Kessler, Author of "Running Money: Hedge-Fund Honchos, Monster Markets, and My Hunt for the Big Score" (Oct. 7, 2005)

Steven Pearlstein: This is libertarian nonsense. Sometimes regulations backfire, sometime they are badly written, sometime they are badly administered. Just like some hedge fund guys are crooks and charlatans. The reason we have developed a regulatory framework over the years is that we have learned the lessons of a purely unregulated financial market. And because hedge funds are now so big and important, and manage the retirement money of schoolteachers and firemen and ordinary working folk, we need to begin to put in place modest (let me repeat, modest) safeguards to deter fraudulent behavior, at the least. It is simply a lie that only sophsiticated money managers and investors deal with hedge funds. As my colleague Ben White revealed in a story in the Post in August, you have pension funds and college endowments that are way over their heads when it comes to investing in these things. And many of them are put into hedge funds by brokers who have conflicts of interest and don't do due diligence. You can say that the market will eventually surface these charlatans and incompetents. But it is certainly reasonable for people not to want to take that chance and to try to increase the chance that they will be deterred or surfaced earlier through a bit more transparancy -- that is, filing audited financial statements. Warren Buffett files audited quarterly financial statements, and I don't see how that has prevented him from doing well for himself and his investors.

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Running Money: Hi Steve,

I enjoy your work, but I have to disagree on more regulation. Hedge funds actually have $7 trillion under management with over 5,000 funds. You will have some bad apples, some charlatans.

How many investors have the $5m liquid networth or often $1 -$10 million minimum investment? Surely less than .5% of the US population. Shouldn't it be on the investor or endowment fund to do some due diligence? There are plenty of great, honest, managers with long term performance such as Tudor Investments, Bruce Kovner, or Steve Cohen. Peter Lynch said investors spend more time analyzing which washing machine to buy than their investments.

I also think the top talent will go elsewhere then. To Nevis, Geneva, Bermuda ... I don't think it would be good for us as top talent would go where it is welcome.

I have believed for quite a long time that the hedge fund regulation is more related to an invasion of privacy. Our government wants to keep tabs on who these investors are and where the money comes from. Simple as that. Why does this person in Bulgaria, Algeria, or Peru have $1 billion dollars? The government is not trying to regulate former lawmakers working as lobbyists or members of industry, which has far greater potential for abuse than hedge funds. It is all a farce.

George Soros cleared the $1 billion dollar a year mark several times. He actually did it one play, shorting the Pound Sterling over a decade ago.

Thanks for the discussion.

Steven Pearlstein: I believe George Soros did it largely by using his own money, not by taking 25 percent off the top of other people's money plus charging a 2 percent annual fee. That's a big difference in my book.

I believe the figure that is generally accepted is $1 trillion, and 8,000 funds.

The notion that we shouldn't regulate or tax any business or rich person because they can always go to Bermuda is the kind of hokum we hear all the time in Washington. Its so hackneyed even the lobbyists don't bother using it. Let them go. And then deny them access to the U.s. market if they abuse it.

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washingtonpost.com: As Hedge Funds Go Mainstream, Risk Is Magnified (August 11, 2005)

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Tampa, FL: As long as hedge funds only allowed truly high net worth investors who could afford a minimum $1 million investment, they could legitimately claim their investors were big boys who understood the risks and could afford the loss. But now hedge funds have lowered the bar and allow minimum investments of a paltry $25,000. Banks are structuring products for the average investor to move into hedge funds. Next thing you know, you'll be able to walk into your local bank branch and buy this stuff from your teller. This development, more than any other, justifies federal regulation.

Add to this the under-appreciated counterparty risk on OTC credit derivatives hedge funds use to juice returns on "top secret" investment strategies, as well as such structured credit products as synthetic CDOs of synthetic CDOs (CDO squared), and we have the makings of a real crisis. Even if Refco doesn't disrupt the credit derivatives markets, we cannot be assured the next Refco--and there WILL be another Refco--will not do so. Regulating hedge funds is nothing more than financial self defense for the US economy.

Look back to Enron. Laissez-faire theologists, such as Wendy and Bog Graham, kept the CFTC from regulating energy derivatives, and look what happened. Now the same set of economic Wahabbists are trying to "save" hedge funds from the "evils" of regulation--and they don't care about the costs to the economy and society.

Some forms of regulation works. And hedge funds need it NOW.

Steven Pearlstein: Couldn't have said it better myself.

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Silver Spring, MD: I'm seeking your opinion here rather than leveling any kind of critique. Do you feel that there is something inherently "shady" about the hedge fund business? Not considering the criminal behavior you cited in the intro, do you feel that whatever rules there are for hedge funds are inadequate or overly lenient?

Steven Pearlstein: No, there is nothing inherently shady. Never said that. Never meant to imply that, if somebody took that implication. Why is why you'd think the good operators would want to put some mechanisms in place to keep the charlatans and crooks out, and send the incompetents packing.

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Lampert: Actually Lampert has outgunned Buffett for quite a while now. Will he be as successful, I don't know? He deserves every penny he earns for sure 29% a year since 1988, that is out this world.

http://www.businessweek.com/magazine/content/04_47/b3909001_mz001.htm

I am thankful for all these managers ala Icahn and Lampert, they create shareholder value and save companies from bloated management. Those are the real Charlatans, your Cases, Eisners, Saylors, etc... When a company goes public and issues shares it is run for shareholders. You can't tap the capital markets when you need something, but then complain that hedge fund managers sell off nonperforming divisions, fire middle managers, and cut back on perks. Every CEO knows that. Don't issue shares then, kept your company private.

I hope Icahn and these guys pound Time Warner, then maybe the stock will be worth something again.

Steven Pearlstein: That's your opinion. I find a billion dollar a year pay package a bit piggy myself, but that's just a personal matter. I'm not suggesting that the government do anything to Eddie Lampert other than require him, and everyone else in his industry, to file quarterly, audited reports with his investors and the SEC (whether they are made public is another question). And the SEC should randomly review them to make sure they are on the up and up. That's it. Maybe Eddie already does that -- I have no idea (how would I?) But nobody in this discussion has given me one fact, one theory, to suggest why filing audited financial statements will in any way deprive all those worthy hedge fund investors of their extraordinary returns, or heroes like Eddie Lampert his richly deserved billions. If you guys invested as badly as you debated, you'd be running a small college endowment.

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Washington, DC: You seem to have a problem with the fees hedge funds chrge. If hedge fund returns are higher than other funds and make the investment worthy of the fee why do you think this is greedy?

If people think that they are being charged fees that are too high, then they can go elsewhere. If a pension fund -- holding the teacher and firefighters money -- puts money in any poor investment, shouldn't we be looking at the people who administer these funds?

Added regulation or forcing people to cut fees simply causes the best and brightest to move on to something else. It happened in mutual funds and could continue...

Steven Pearlstein: As I said, obviously some investors are willing to pay the fees, at least for now. That's fine with me. I'm happy to let the marketplace sort out the fee structure. That's a red herring. My point in raising Eddie's billion dollar payday is simply to make the point that such high water marks are often a telltale sign of a market top.

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NY NY: I agree completely that regulation in the financial services area is necessary, I'm just wondering whether hedge funds which do not invest on behalf of "retail" customers, even indirectly through pension funds, but which keep to the model of super wealthy or institutional could therefore be subject to less regulation. Could this work? Thanks.

Steven Pearlstein: Less regulation, certainly. No regulation, no. I don't cry much for the wealthy investors. But institutions are managing the money of ordinary people who may have entrusted their money to people not paying enough attention and doing enough due diligence and too susceptible to following the herd right over the cliff. That's what the recent experience shows. So its perfectly reasonable for those ordinary people to use the governmental process to seek some sort of extra protection by hiring people to look over the shoulders of those money managers. Its one thing to say that the market will correct for the bad actors. Maybe it will. But if its your money that has to get sacrificed for the market to do its work, that's not a very comforting thought, is it. And it is perfectly rational to want to give up a quarter of a point on the return in order to get some piece of mind and lower the odds that some crook is going to pick you clean.

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Running Money: Steve you are correct it is $1 trillion. Soros made $1b the Quantum fund with at least 20% of profits as his fee. Most star managers have a substantial piece of their networth in the hedge funds.

Steven Pearlstein: Fair enough. Not sure what that proves. I can tell you today that there is a hedge fund bubble and that the air is coming out of it. Too much money going to too many mediocre managers, or worse.

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Steven Pearlstein: Thanks folks. See you next week.

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