Hauling hedge funds into the 21st century

Without question, the profile of the average hedge fund investor has changed in the last few years. Battered by the financial crisis that erased billions of dollars in stock market value just a few years before the first Baby Boomers were scheduled to retire, many pension fund managers started investing with hedge funds in the hope of making up lost ground by taking advantage of their customized, often quant-driven investing strategies and promises of “absolute returns” regardless of the markets’ direction.

{mosads}Consequently, hedge funds – which now number more than 7,000 and manage some $2 trillion in assets –are increasingly dealing with fiduciaries managing other people’s money, rather than investing for their own account or on behalf of wealthy individuals. Cliffwater, a consulting firm that tracks the industry, reported that more than half of the 96 state pension plans it surveyed had invested a total of $63 billion with hedge funds by the end of fiscal 2010 — more than double the amount invested only four years previously. “Public pension funds are the investment group that is going to shape the hedge fund industry,” Scott Carter, co-head of hedge-fund consulting for Deutsche Bank, told Institutional Investor. The California Public Employees Retirement System, the country’s largest public pension fund, had a reported $5.2 billion invested in hedge funds by the end of last year.

Corporate pension plans, which control $1 trillion in assets, are also following suit.  “We are expecting hedge fund allocations to double across pension-plan types, from to an expected 10% target,” the director of marketing at hedge fund Cube Capital, recently told Marketwatch. Hedge-fund investing has been democratized, albeit indirectly.

Last year the hedge fund industry recorded one of its best years ever. Institutional investors poured an estimated $40 billion of new cash into funds during the first 10 months of 2011, a 24% increase over the year before, according to Pensions & Investment; it was the second-highest amount recorded since P&I started tracking hedge funds inflows in 2004. And that figure represents only deals that were publicly announced; many institutional investors prefer no publicity when striking a deal to invest in a fund.

Commanding enormous pools of capital, hedge funds have amassed significant economic clout. Combined, the top 10 U.S. hedge funds control financial assets valued at $325.5 billion, according to Bloomberg. The country’s top hedge fund, Westport, Conn.-based Bridgewater Associates controls assets of nearly $78 billion — an amount only slightly less than the annual sales of Costco Wholesale (No. 28 on the Fortune 500 list) but well ahead of such venerable brands as Home Depot, Target and Boeing.

And yet it is increasingly clear there is a serious ethics lapse hitting a portion of the hedge fund sector. In the past two years, there have been nearly 60 convictions or guilty pleas by hedge fund executives and consultants. Chief among them: Raj Rajaratnam, the billionaire manager of Galleon Fund who was sentenced last November to more than 11 years in prison and fined $10 million for masterminding a trading scheme that netted almost $54 million in illegal profits; the Securities and Exchange Commission ordered Rajaratnam to pay $93 million in a related civil case. Joseph Skowron III, former manager of FrontPoint Partners – and a Yale-educated physician – was given a five-year sentence for conspiracy to commit securities fraud and obstruct an SEC investigation after he admitted trading on non-public information.

More revelations are certain. The SEC is investigating trading activities of Harbinger Capital Partners and its manager Philip Falcone regarding allegations it gave preferential treatment to some blue-chip clients, including Goldman Sachs, at the expense of other investors – private investors have already filed suit against Harbringer. Regulators are examining SAC Capital Partners, the $12 billion hedge fund run by Steven Cohen after two of his former managers pled guilty to insider trader and agreed to cooperate with federal prosecutors. Diamondback Capital Management, which manages $2.5 billion in assets, was recently ordered to pay $9 million in fines and penalties stemming from a government investigation into its insider trading activities.  And in late January, prominent hedge fund manager David Einhorn, head of Greenlight Capital, was hit with a fine of $11.2 million by British regulators for “market abuse” by dumping shares of leading UK-based pub operator Punch Taverns ahead of a stock offering. Stay tuned.

There’s no single fix to cleaning up the hedge-fund industry. But here’s a good place to start: strengthen the laws under which most funds operate so that their fiduciary duties are explicit, irrevocable and publicly recognized. Remarkably, that is not the case at present. Most U.S. hedge funds are incorporated as limited partnerships in Delaware. Under Delaware’s Revised Uniform Limited Partnership Act which took effect in 2004, a partnership’s general partners are legally permitted to void the fiduciary duties they owe to their limited partners – their investors. They can also disclaim all liability when they take action in reliance on the opinion of an investment banker. Considering how many instances there’ve been of bankers and third-party consultants covering up or facilitating wrongdoing, this provision is an invitation to fraud and abuse.

In fact, some law firms are now marketing their ability to draft general partner agreements that leave limiteds unprotected and managers secure from accountability. Broad indemnification provisions are just one of a list of other one-sided protections being written into these agreements.

These types of limitations and agreements may make sense when a partnership is a small entity with a group of persons who know each other. They make no sense in the context of a $2 trillion industry with $70 billion behemoths. How would shareholders of Exxon Mobil, Wal-Mart or General Electric respond if their managements said that they had no fiduciary obligation to their millions of investors? The uproar would rattle Wall Street to its foundation.

Hedge fund customers need to take note. Fiduciaries who are investing their beneficiaries’ money need to take action. Lawmakers need to do their job and provide a legal regime that protects minority investors.

Jay Eisenhofer is managing director of leading investor rights law firm Grant & Eisenhofer.