Should Hedge Funds Face Harsher Regulation?

As if the fallout from financial meltdown wasn't enough, there's another stiff challenge facing the world's investment-fund industry. Only this time it's from Brussels. Fresh E.U. proposals would require hedge funds, private equity and a host of other alternative investment funds to meet tougher regulation before they can market to investors in the region. The legislation — tabled for discussion in late April in an effort to shore up investor protection while reducing risk — has attracted growing criticism. London-based AIMA, a global hedge-fund industry group, calls proposed disclosure requirements bureaucratic. Kinetic Partners, a consultancy for the U.K. hedge-fund industry, reckons meeting stricter capital requirements and risk-management rules could cost British funds as much as $5 billion. For those outside the E.U., though, the proposals are just as stern. Managers or funds elsewhere in the world that don't meet equivalent regulatory standards will be barred from touting to European investors. "Basically," says Julian Korek, founding member of Kinetic, the region "becomes fortress Europe."

Beating up on hedge funds or private equity on the tail of a banking crisis is itself a little puzzling. Official reports into the financial crisis — such as the British government-commissioned Turner Review, published in March — assigned such funds only a peripheral role in the tumult. National politicians have been quick to come to their defense. "It is not private equity that caused the crisis, nor hedge funds," Mats Odell, Sweden's financial markets minister said earlier this month in the context of the E.U.'s proposals. "But in some countries, the political debate portrays [them] as the problem." Paul Myners, a British government minister with responsibility for the U.K.'s financial-services sector — home to 80% of Europe's roughly $400 billion in hedge-fund assets — accused other E.U. governments July 7 of making "political capital out of demanding intrusive regulation of an industry of which they have little or no direct experience." While it acknowledges they didn't trigger the crisis, the European Commission has insisted that "risks associated with their activities ... may in some cases have contributed to market turbulence."

The plan to close off Europe to managers or funds outside the E.U. that aren't subjected to equivalent regulation — a provision that would kick in three years after the rest of the legislation, giving jurisdictions and managers time to adapt — promises the most significant change. The E.U.'s approach is understandable. If you want to protect European investors, it's no good regulating domestic fund managers if those selling to investors from outside the region aren't obliged to respect similar rules. But while U.S. efforts are underway to bolster the policing of hedge funds — and the meaning of equivalent regulation is still to be defined at the E.U. level — as it stands, "regulatory equivalence between the United States and European countries does not exist," says Andrew Baker, CEO of AIMA. "As of the date of introduction of that measure, you would have a lock out of all American managers from the European Union." That limits investors' choice, Baker says, especially since almost all E.U.-based managers market funds domiciled outside the region.

Amid strident criticism from industry and national governments, the proposals — currently being scrutinized by both the European Parliament and European Council, which represents national governments at the E.U. level — will almost certainly be amended. Sweden's Odell insisted the legislation was "a raw diamond that needs to be polished more." Myners, the British Minister, has vowed to "fight tooth and nail" to get the draft revised. Industry groups, meanwhile, have mounted keen lobbying campaigns. With nothing likely to enter into force before 2011, "there's one safeguard against it being introduced as it is," says AIMA's Baker. "It's mumbo jumbo."