Hedge Fund Managers Retaining “Private Regulators” to Demonstrate a Credible Commitment to Compliance

Trust is at the heart of the relationship between hedge fund managers and hedge fund investors.  While some investors have bargained for significant transparency, managers are almost always at an informational advantage vis-à-vis their investors with respect to their specific investment activities.  Those gaps in information are generally filled by two elements: law and trust.  Since law is an imperfect and often ex post remedy, trust remains the glue that holds the investment management relationship together.  But in the wake (or the midst) of a lengthy credit crisis, the Madoff scandal and a wave of redemption suspensions and gate impositions, trust is in short supply among hedge fund investors.  In practical terms, this translates into one of the toughest money-raising and money-retaining environments on record.  In response to these dynamics, the role of third-party service providers to hedge funds and managers has been evolving in ways that would have been difficult to foresee in early 2007.  Specifically, a growing number of hedge fund managers have been granting third-party administrators and other service providers unprecedented powers over their investments and operations.  For example, as discussed more fully in this article, the London-based manager of the recently-launched Gyldmark Liquid Macro Fund has empowered PCE Investors to block trades outside of the fund’s mandate and to liquidate the fund (consistent with its governing documents) if the fund is down more than ten percent in a given year.  Managers are granting such powers to service providers as a way of credibly demonstrating to current and potential investors an irrevocable commitment to compliance and best practices.  In such circumstances, the role of the service provider has evolved from solely providing services to the manager or fund to providing an objective check on the manager’s activities.  For this reason, service providers retained to provide such a role have come to be known as “private regulators.”  And in various cases they are providing a level of de facto regulation more draconian than anything proposed in Congress, by the Obama administration or by EU authorities.  We outline the services traditionally provided to hedge funds and hedge fund managers by third-party service providers; the shift to private regulation and the specific types of powers granted to private regulators; doubts expressed by some market participants about the practicability of private regulation; liability and indemnification concerns; and procedures regarding reporting of violations or suspected violations and “noisy withdrawals.”

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