Sunday 29th May 2016
NEWS TICKER, FRIDAY MAY 27TH: BGEO Group plc, the London listed holding company of JSC Bank of Georgia, has this morning announced that Bank of Georgia, Georgia’s leading bank, and the European Bank for Reconstruction and Development (EBRD) have signed a GEL220m (approximately £70m) loan agreement with a maturity of five years. EBRD obtained the local currency funds through a private placement of GEL-dominated bonds arranged by Galt &Taggart, a wholly owned subsidiary of BGEO. This is the largest and the longest maturity local currency loan granted to a Georgian bank, which will allow Bank of Georgia to issue longer-term local currency loans, providing essential support for micro, small and medium sized enterprises to converge to DCFTA requirements, as well as underserved women entrepreneurs. “We are keen to develop financial products and lending practices, to service specifically women-led SMEs, which will ultimately increase their involvement in developing Georgia’s private sector”, says Irakli Gilauri, CEO of BGEO Group - The UK’s CBI has responded to analysis from the Treasury showing that a vote to leave the European Union could negatively impact UK pensions. Rain Newton-Smith, CBI Economics Director, says that: “All pension schemes benefit when funds can be invested across a stable, growing economy, to best support people in their retirement years. Any financial market turmoil caused by a Brexit is likely to have a negative effect on household wealth, the value of funds and damage pensions here at home, especially for those looking to retire within the next few years. The sheer weight of credible evidence points towards a serious economic shock if the UK were to leave the EU, meaning a hit to the value of our private pensions, jobs and prosperity.” - EPFR Global reports that Nine weeks into the second quarter mutual fund investors remain underwhelmed by their choices as they seek to navigate a global economy characterized by political uncertainty in Europe, lacklustre corporate profits and the prospect of another interest rate hike in the US, economic stress in major emerging markets and Japan's experiment with negative interest rates. During the week ending May 25 all nine of the major EPFR Global-tracked Emerging and Developed Markets Equity Fund groups posted outflows, as did Global, High Yield, Asia-Pacific and Emerging Markets Bond Funds, seven of the 11 major Sector Fund groups and three out of every five Country Equity Fund groups. Alternative Funds look to have taken in over $1bn for the fifth time in the past 14 weeks. Overall, EPFR Global-tracked Bond Funds added $2.6 billion to their year-to-date tally while another $9.1bn flowed out of Equity Funds. Some $12bn was absorbed by Money Market Funds with US funds attracting the bulk of the fresh money. EPFR Global-tracked Emerging Markets Equity Funds remained under pressure from many directions. China's economic data and policy shifts continue to paint a mixed picture for growth in the world's second largest economy, the US Federal Reserve is talking up the prospects of a second rate hike this summer, Europe's recovery appears to be running out of stream and the recent recovery in commodities prices is being viewed with scepticism in many quarters. All four of the major groups recorded outflows during the week ending May 25, with the diversified Global Emerging Markets (GEM) Equity Funds seeing the biggest outflows in cash terms and EMEA Equity Funds in flows as a percentage of AUM terms. Latin America Equity Funds extended their longest outflow streak since late 3Q15 as investors who bought into the prospect of political and economic change in Brazil confront the messy reality. However, year to date Brazil has been the top emerging market for all EPFR Global-tracked Equity Funds as managers bet that the impeachment proceedings against President Dilma Rousseff will open the door to more centrist economic policymaking says the funds data maven. Among the EMEA markets, the firm reports that GEM managers are showing more optimism than investors. EMEA Equity Funds have now posted outflows for five straight weeks and investors have pulled over $300m out of Russia and South Africa Equity Funds so far this month, though GEM allocations for both South Africa and Russia climbed coming into this month. The latest allocations data indicates less optimism about China despite is still impressive official numbers - annual GDP was running at 6.7% in 1Q16 - and the edge the recent slide in the renminbi should give Chinese exporters. GDP growth in Emerging Asia's second largest market, India, is even higher. Elsewhere, India Equity Funds have struggled to attract fresh money as investors wait to for domestic business investment and the government's reform agenda to kick into higher gears says EPFR Global – According to New Zealand press reports, stock exchange operator, NZX, will initiate confidential enquiries into listed companies that experience large, unexplained share price movements, to determine whether they may be holding undisclosed "material" information even while remaining in compliance with the market's Listing Rules that require disclosure of material information at certain trigger points. In an announcement this morning, NZX also warned investors not to assume that a listed entity's Listing Rules compliance statements meant they did not have material information in their possession which would potentially require eventual disclosure - Asian stocks were modestly higher today, largely on the back of increasingly softening sentiment from the US Federal Reserve. Most people think there will be one rate hike this year, but likely it will be in July rather than June. Either way, it will be one and not two or three. Fed chair Janet Yellen is scheduled to talk about interest rates at an event at Harvard University today and the expectation is that a softer approach for the rest of this year will be writ large; a good signal of intent will follow today’s quarterly growth stats. The presidential election will encourage caution; continued market volatility will encourage caution and mixed manufacturing data will encourage caution. Japan’s benchmark Nikkei 225 index added 0.4% to touch 16,834.84 and Hong Kong’s Hang Seng rose 0.9% to 20,576.52. The Shanghai Composite Index gained 0.3% to 2,829.67. The Straits Times Index (STI) ended 6.65 points or 0.24% higher to 2773.31, taking the year-to-date performance to -3.80%. The top active stocks today were SingTel, which gained 1.05%, DBS, which gained 0.07%, UOB, which gained0.11%, Keppel Corp, which gained2.47% and Ascendas REIT, which closed unchanged. The FTSE ST Mid Cap Index gained 0.27%, while the FTSE ST Small Cap Index rose 0.30% - The European Bank for Reconstruction and Development (EBRD) says it is taking the first step towards developing a green financial system in Kazakhstan in partnership with the Astana International Financial Centre (AIFC) Authority. EBRD President Sir Suma Chakrabarti and AIFC Governor Kairat Kelimbetov signed an agreement today on the sidelines of the Foreign Investors Council’s plenary session to commission a scoping study for the development of a green financing system in Kazakhstan. The study, scheduled to be completed in 2017, will assess the demand for green investments, identify gaps in current regulations, and make recommendations for the introduction of green financing standards and for the development of the green bonds market and carbon market services. The development of a green financing system would be consistent with the COP21 Paris Agreement, aligning financing flows with a pathway towards low greenhouse gas emissions and climate resilient development. The AIFC Authority was put in place earlier this year and is tasked with developing an international financial centre in Astana. In March, the AIFC Authority, TheCityUK and the EBRD signed a Memorandum of Understanding to support the establishment of the financial centre and to encourage and improve opportunities for the financial and related professional services industries – Turkey’s Yuksel has issued notice to holders of $200m senior notes due 2015 (ISIN XS0558618384), and filed with the Luxembourg Stock Exchange, that the company has agreed a term sheet with the ad-hoc committee of noteholders and its advisors to implement a restructuring of the notes and is currently finalising the required scheme documentation with the Committee. Once agreed, the Company will apply to the English High Court for leave to convene a meeting of note creditors to vote on the scheme proposals as soon as reasonably practicable when the High Court reconvenes after vacation in June 2016 - Following the agreement in principle of the May 24th Eurogroup for the release of the next loan tranche to Greece, domestic authorities have intensified their efforts for the completion of all pending issues reports EFG Eurobank in Athens. According to Greece’s Minister of Finance Euclid Tsakalotos, on the fulfilment of all pending issues, €7.5bn will be disbursed in mid-June, of which €1.8bn will be channeled to clear state arrears – This weekend is the second UK May Bank Holiday. FTSE Global Markets will reopen on Tuesday, May 31st at 9.00 am. We wish our readers and clients a sunny, restful, safe and exceedingly happy holiday.

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After the Deluge

Saturday, 01 January 2005
After the Deluge In late October the US Securities and Exchange Commission (SEC) voted three to two in favour of hedge fund registration. SEC chairman William Donaldson had pushed hard for registration, arguing that as less well to do investors increasingly put their money into hedge funds, not enough is known about them. Even so, money has continued to flood into hedge funds during 2004, sometimes from surprising sources. By some estimates, industry assets now exceed $1trn. Neil O’Hara assesses the impact of tighter regulation and the general outlook for an industry that has promised much and yet this year, at least, has delivered only a lacklustre performance. http://www.ftseglobalmarkets.com/
In late October the US Securities and Exchange Commission (SEC) voted three to two in favour of hedge fund registration. SEC chairman William Donaldson had pushed hard for registration, arguing that as less well to do investors increasingly put their money into hedge funds, not enough is known about them. Even so, money has continued to flood into hedge funds during 2004, sometimes from surprising sources. By some estimates, industry assets now exceed $1trn. Neil O’Hara assesses the impact of tighter regulation and the general outlook for an industry that has promised much and yet this year, at least, has delivered only a lacklustre performance.
The number of hedge fund start-ups continues to grow dramatically,” says James Hedges, founder, president and chief investment officer of LJH Global Investments, an advisory firm that helps clients select and invest in hedge funds, “The demand for hedge funds is unabated, the number of hedge fund managers bringing in substantial assets is unbelievable.” Hedges notes that investors are gravitating to “mega-funds” that manage $500m or more. “It is creating a very bar-belled industry. Some 90% of the industry’s assets are clustered around 10% of the number of funds out there, and the remaining 90% of funds hold 10%,” he says.  As a consequence smaller players face immense pressure to escape the competitive disadvantage of subscale operations.

Funds of hedge funds account for an increasing proportion of new money flows. “I estimate that 80% of funds coming into hedge funds go through funds of funds today, up from 50% two years ago,” says Hedges, “They are the conduit of choice because they have the capability to do professional due diligence and ongoing monitoring. You get diversification across strategy, across managers, you get risk mitigation. You make it somebody else’s problem.”



Even so, outsourcing of fiduciary responsibilities comes at a steep price. “The funds of funds business is going to be plagued by its mediocrity,” he says, “Most of them have terrible performance. It is all going to get out there at some point. It is two or three years out.”

“A typical fund of funds, if it is trying to hedge its bets all over the place and be totally diversified, becomes closer to an index fund,” expands Michael Tannenbaum, president of the Hedge Fund Association in New York. “The value added by the manager in picking the sub-funds diminishes.”

Funds of funds levy management fees up to 1% and performance fees up to 10% on top of the underlying funds’ 1%-1.5% management fees and 20% performance fees. “Some of the funds of funds are reasonable, some aren’t,” he says, “A number don’t charge performance fees, or charge performance fees that are very modest, or that are modest and in excess of a benchmark.”

As assets under management balloon, spreads have shrivelled for some popular strategies, such as merger and convertible arbitrage. Although merger activity has picked up, total transaction volume remains far short of the peak reached in 2000. Convertible bond issuance has not kept pace with hedge funds’ asset growth, either. “The market becomes more efficient as the amount of money and the number of players increases,” notes Tannenbaum.

The search for higher returns is leading hedge funds into commodities, exotic securities and even private equity, which increases the risk. “Illiquid investments are inconsistent with a strict hedge fund model,”  Tannenbaum explains.  “Hedge funds typically are open-ended products.  Private equity or venture capital investments are illiquid.  As a result there are valuation problems.” Hedge funds segregate private equity deals into “side pockets” that lock in participating investors until the underlying investment liquefies, fixing the value.

Government agencies in Washington are split over the merits of hedge funds. The Federal Reserve, the central bank of the United States (US), more commonly known as the Fed, and the Treasury Department relish the liquidity they provide. On the other side, the Securities and Exchange Commission (SEC) looks at them askance. “I sat down with Alan Greenspan and with (Treasury) Secretary Snow and his staff, and they are just so delighted that hedge funds are there in the illiquid markets,” says John Gaines, president of the Managed Funds Association (MFA), “Then you go to the SEC and they say we have valuation problems. It is like you have crossed a border.”

Valuation difficulties extend to over-the-counter swaps, derivatives and other securities for which no ready market exists. “There is no such thing as an independent valuation service,” scoffs Hedges at LJH, who believes the lack of valuation standards is the biggest threat to the hedge fund industry, “The administrators cannot do it; they do not understand the instruments.” In the absence of a market price, managers follow procedures described in their partnership agreements – which they drafted. “It is quite arbitrary,” he says, “Hedge fund managers are the ones that decide or define valuation – not a market maker, not a broker dealer, not an auditor, not an administrator.”

In its 2003 report Sound Practices for Hedge Fund Managers, the MFA recommends a fair value approach but recognises the limitations for illiquid securities. “The value of that money going into our capital market outweighs the difficulties that are associated with valuation,” says Gaines, “That’s not to say there’s a simple answer to valuation, but it is one of full disclosure and consent by the investor.”

Fraud based on bad valuations contributed to the SEC’s decision to force most US hedge fund advisers to register by February 1, 2006. The agency ignored intensive lobbying by the MFA, the US Chamber of Commerce (USCC) and others opposed to regulation. The rule captures advisers who manage more than $30m and have more than 14 US investors in funds with a lock-up period less than two years. Longer lock-ups let private equity and venture capital funds off the hook.

Tannenbaum worries the incremental cost may deter some younger players, who might otherwise bring new ideas and energy to the industry. He also fears registration is the thin end of a regulatory wedge. “I refer to it as the slippery slope problem,” he says, “Okay, we will file the form and we will adopt the rules, but where does that lead to?”

The SEC acknowledges it must “recognise the important role that hedge funds play in our markets” and denies any intent to dictate hedge fund strategies. Its assertions convince no one. “Of course there is more to come,” says LJH's Hedges. “It is unfortunate the US is starting to increase regulation at a time when the rest of the world is starting to liberalise their regulatory regime.” He believes the new rule is wasteful and misconceived. “I don’t believe It is going to protect the retail investor. I don’t believe it is going to protect any investors.”

Tannenbaum suggests that foreign hedge fund managers, many of whom already face regulation in their home country, may be reluctant to submit to multiple jurisdictions. “Maybe there should be some reciprocity,” he says, “I fully understand that there’s no reason the SEC should give a person registered with the Financial Services Authority in London a pass. They could sort that out.”

Foreign managers may prefer to evict enough US investors to escape the threshold rather than submit to SEC scrutiny. “I think some funds will jettison that number of US investors to get under 15 so that they can avoid duplicative and perhaps inconsistent regulation,” says Gaines. Sophisticated investors will have fewer choices if foreign managers forsake the US market.

The USCC believes the SEC lacks authority to impose the new rules and has threatened to file suit. In 1985, the SEC defined a “client” under the Investment Advisers Act to include a limited partnership but not individual limited partners because they do not receive independent advice. A letter commenting on the SEC's proposals from Wilmer Cutler Pickering Hale and Dorr LLP argued that legislative history back to 1940 supports this approach.

When Congress amended the Act in 1970, it altered the registration requirement but not the way advisers count clients. “If Congress has met, tinkered with the statute, made changes, and not seen fit to change or override an interpretation, there’s a presumption that the interpretation is correct and has the approval of Congress. Therefore, to change that interpretation requires an Act of Congress,” Tannenbaum explains, “That is the argument. I do not know if it has legs.”

Although the MFA has fought hard against registration, it has no plans to challenge the rule. “That is history. We lost and we are going forward,” Gaines says, “We look forward to working with the SEC. If they need to develop information and knowledge about the hedge fund industry, we are in a unique position to provide it to them.”

Gains points out that registration brings other rules into play. Registered advisers must adopt a written code of ethics and appoint a chief compliance officer. “It is not just putting a postage stamp on a form and sending it in,” he says.

The SEC argues the rule does not impose a significant burden because many hedge fund advisers have already registered. Mindful of their fiduciary responsibilities, most institutions allocate money only to registered hedge fund advisers. “Quite apart from the Commission’s actions, any major player in this business, or any wannabe (sic), would have had to register anyway,”  Tannenbaum says, “I think the industry needs to be realistic about that.”

As more pension plans invest in hedge funds, the pressure to register increases. Any fund that has more than 25% of its assets from the Employment Retirement Income Security Act (ERISA) plans, which covers a wide range of employee benefit plans, becomes subject to the “plan asset” rule.

“The application of the plan asset rule is inconsistent with operating a hedge fund,” Tannenbaum says, “It interferes with performance fees, interferes with soft dollar arrangements.” A hedge fund manager can avoid the plan asset rule by becoming a Qualified Professional Asset Manager if it meets three tests, including $750,000 net worth in the management company and at least $50m under management. “Guess what the third is?” asks Tannenbaum rhetorically. “You have to be registered as an investment adviser.”

Hedges distinguishes SEC registration (that he vehemently opposes) from the Treasury’s proposed anti-money laundering rules for investment advisers. “Regulation that protects our national interest so that unregulated vehicles don’t become conduits for people who gained their capital illegally, or use it illegally, that’s a different deal,” he says.

MFA members share that view, according to Gaines, because anti-money laundering has a demonstrable benefit. Hedge funds have no desire to shelter money derived from criminal enterprises, political corruption or terrorists. “I didn’t have one member object to what the Treasury proposes to do,” he says, “In fact, they were extremely supportive with their talent and their money and their time to develop guidance to Treasury to get it right.”

Tannenbaum hopes the Treasury Department issues final money-laundering rules soon. “The worst thing about rules is not knowing what they are,” he says, “You might have people doing it one way, and then all of a sudden you have another evolutionary scheme out there, and as time goes by they continue to diverge.” He describes the final rules as “regulatory vapourware”. The Treasury published the proposed rules in April 2003. Hedge fund managers won’t have to wait for new rules governing deferred compensation to take effect. Many US-based offshore fund managers defer their share of the performance allocation, which allows them to avoid paying tax until a later date. They did not change the creditor relationship; they just made it harder for the creditors,” Tannenbaum explains, “Offshore rabbi trusts are outlawed by the new rule.”

Offshore rabbi trusts are trusts set up in foreign jurisdictions to fund non-qualified deferred compensation programme. Generally speaking a rabbi trust is nothing more than a promise to pay compensation at a later date.  Rabbi trusts have commonly been used as top-hat deferred compensation plans for high ranking executives. Under these plans a beneficiary can put stocks, insurance policies or other assets in trust.  As a result, a number of hedge fund managers have used offshore rabbi trusts as a means to defer income from current taxation. US regulators have been concerned however that offshore rabbi trusts are set aside often out of reach of a corporation’s creditors – which actually defeats the original purpose of the US Inland Revenue Service allowing them in the first place. Under recent legislation, managers can still defer compensation, but must accept tighter restrictions as well as greater exposure to credit risk – although few managers will have to worry about large deferrals in 2004.

For 2005, the MFA has its work cut out to prepare members for registration. “It is education, seminars, compliance guidance; all kinds of things go into the implications of that rule. It is huge,” says Gaines.

Will performance rebound? Perhaps – but the deluge of money may make it harder for managers to deliver excess returns.

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