HEDGE FUND NEWS
@ Mon 09 July 2007 : GMT

FINTAG COMMENT

With a weekend of two Wimbledon tennis finals, the great Formula 1 let down (Lewis who?), a bunch of junky cyclists starting the Tour de France from London and Live Earth where buzzed in pop stars ranted on about global warming (don't make me laugh), it is good to get back to the real world of "potential" market volatility.

Hedge Funds are the poor cousin to Sovereign Wealth Funds.

Goldman makes more money abroad; starts sell off of its real estate portfolio.

Rating agencies given a subprime kicking in Ohio.

Hong Kong gets twitchy over Hedgies.

The buyout party is over.

Hedge Funds - nimble, quick, smart; Private Equity Funds - illiquid, slow, thick.

OTHER NEWS

Why the Rich Get Richer, Hedge Funds Fail and Slaughters Occur (bloomberg)

Children to get lessons in money - and debt (times)

Distressed insecurities (nakedshorts)

Fixing Typos by Web Users, Without Raising Hackles (nytimes)

Disgusted With Hedge Funds? Fight Back (thestreet)

Subprime risks come home to roost for hedge funds (reuters)

Hedge funds eye Mexico amid US subprime woes (reuters)

BAD MOOD BEAR

Ratings agencies are accused over sub-prime risks (times)
The attorney-general for the state of Ohio has accused the financial ratings agencies of fuelling America's mortgage crisis by turning a blind eye to the risks attached to bonds backed by “sub-prime” home loans.

Marc Dann is targeting the agencies as part of an investigation into aggressive lending practices after mortgage banks foreclosed on more than 180,000 home loans in Ohio in the past 2½ years.

Wall Street firms took on many of the riskiest home loans from the mortgage banks and packaged them into bonds. These were given a risk rating by agencies such as Fitch, Standard & Poor's and Moody's and sold to pension funds and other institutions.

Mr Dann, who is preparing a case against the agencies but has yet to file formal charges, said: “The ratings agencies helped to keep the market on fire by ensuring that these bond offerings got high enough ratings for them to sell, providing new funds for the mortgage originators to make new loans to increasingly unsuitable borrowers.

“They aided and abetted the process by blessing these issues, even though they knew, or should have known, that many of these bonds were backed by mortgages that had been fraudulently made.”

Many of the securities backed by sub-prime mortgages continued to receive top risk ratings, despite growing evidence of lax lending practices, because most institutions are barred from buying high-risk securities, Mr Dann alleged.

Moody's denied the allegations, saying: “Our opinions are objective and not tied to any recommendations to buy and sell.” Fitch and Standard & Poor's declined to comment.

UNREAL ESTATE

Goldman Sachs sales of big property portfolios in Germany raises fears that foreign property investors are heading for the exit (finfacts)
US investment banking giant Goldman Sachs has put two German property portfolios valued at up to €3bn ($4bn) on the market in a clear sign of international investors exiting the market.

The Financial Times reports today that Goldman is selling €1.1bn of offices, which it had split off from a €2.6bn portfolio bought in May from fund manager Degi. It is also selling a 51 per cent stake in a €4.5bn portfolio of Karstadt department stores. KarstadtQuelle, the retailer that owns the 49 per cent of the joint venture, has already put its stake on the market.

Irish Investment in Germany

Irish investors have put an estimated €41 billion in commercially property, mainly overseas, since 2001, compared with a €1 billion in venture capital in Irish business. Until the recovery of the German economy, London has been the location of choice. In recent years attention has turned to Germany.

For example, CMC Capital, a unit of a firm of chartered accountants in the seaside town of Clonakilty in West Cork, says that its has invested €500 million on behalf of clients (some of them likely to be farmers who have benefited from the EU's Common Agricultural Policy that has been mainly funded by German taxpayers) since 2004.

“We have experienced an incredibly strong demand for our German commercial property syndicates from the Irish investment community,” said Derry Crowley, Director with CMC Capital in June.

“The Irish investor follows the property market closely and they clearly see that there are considerable returns to be generated from German commercial property.

“We will look to build on the success we have already enjoyed with our other syndicates and continue to target commercial properties with a bias towards the retail and office sectors located in desirable urban locations throughout Germany.

“Another investment criteria we will look to secure is that the properties purchased are pre-let to blue chip tenants and have an average rental yield of 6.5%,” he added.

A recent syndicate that is expected to run for just over seven years, has a projected rate of return on the investment of about 27% simple per annum.

ECB Rate Rise to 4.50% to Pressure Market

The FT says today that news of the two Goldman deals is likely to raise questions over whether other foreign investors in German property are heading for the door.

The residential market has been a magnet for foreign capital for several years with an estimated 1.3m flats worth €50bn sold since 1999.

However, last week it emerged that Cerberus, the US private equity group, which was recently in the news because of its purchase of the US Chyrsler car division from Daimler Benz, is seeking to sell a €1bn portfolio of 20,000 flats it bought three years ago after failing to realise its expected returns. Cerberus considered a flotation but cancelled it amid falling prices for property stocks.

Fortress, which bought the €3.5bn Gagfah portfolio in 2004, last October spun off 150,000 homes in a Luxembourg real estate investment trust, selling 20 per cent of its holding for €853m.

The FT said that such groups had entered the market hoping to sell flats to their tenants and put up the rents for the rest. But many tenants were happy to continue renting while rent rises are constrained in many cities.

Demand for commercial property has remained strong from international investors who still account for about 75 per cent of purchases.

The FT says rents in most big cities have risen modestly in the past two years, reversing falls from 2001 to 2003. The average rent for prime office space in Düsseldorf, Frankfurt, Hamburg and Munich rose 3.6-7.3 per cent in the first half of the year from last year, according to data released by Jones Lang LaSalle. Prices did not change in Berlin.

The expectation that the European Central Bank will raise its key interest rate to 4.50% next Spring will put additional pressure on investors.

70% FEARFUL OF JOB LOSS

Banks feel the backlash as buyout conditions worsen (financialnews-us)
Seven out of 10 of the biggest leveraged buyouts have yet to be financed in debt markets as concern grows over the weakening of financing conditions.

Rising volatility from hedge fund losses in the US sub-prime mortgage market and an investor backlash over aggressive financing structures is threatening to derail buyouts of Canadian telecoms group BCE, US utility TXU, wireless provider Alltell and First Data Corporation, among others.

Bankers say some $300bn (€220bn) of buyout-related leveraged loans and high-yield bonds are expected to be sold in the second half of the year.

The record £9bn (€13bn) debt package backing the £11bn buyout of UK pharmacy chain Alliance Boots by Kohlberg Kravis Roberts kicked off last week. The deal is a litmus test of sentiment that could define market prospects.

One head of loan distribution at a European bank in London, said: “It's a solid company with a powerful sponsor buying it, but it is a lot of debt to shift in this challenging market.

“I think they will struggle to get the entire £9bn done in one go, and a significant chunk will end up on the banks' balance sheet until they can shift it later.”

Bank of America, Barclays Capital, Citi, Deutsche Bank, JP Morgan, Merrill Lynch, Royal Bank of Scotland and UniCredit are lead underwriting the financing - the largest leveraged loan in the UK buyout market.

Meanwhile, banks working with Cerberus Capital Management are roadshowing its acquisition of US carmaker Chrysler to investors, in a bid to raise an estimated $62bn in debt to finance the deal. Bear Stearns, Citi, Goldman Sachs, JP Morgan and Morgan Stanley have committed to raise the cash.

The turnround in sentiment from one month ago has wreaked havoc in debt markets during the past couple of weeks.

A clutch of leveraged loans and high-yield bond issues have been restructured, and some pulled, after a notable shift in power towards investors following three years when sellers had it one way.

Some bankers are even forecasting the end of controversial covenant-lite loans, which marked the height of borrowers' financing power. Such structures lack the protective covenants, standard in the loan market but not used on bonds, that subject the borrower or company to quarterly tests to show they are maintaining financial ratios at agreed levels.

Sponsor KKR was forced last week to alter its covenant-lite loan financing the near-€1bn ($1.4bn) buyout of Dutch DIY retailer Maxeda.

Underwriters ABN Amro and Citi had to add a maintenance covenant to the deal to get it done. Bankers said that concession was unusual for KKR given the notoriously firm line it typically takes. One leveraged finance banker said: “The is the end of covenant-lite deals in Europe for now, at least for the next few months or so.”

SWF

Higher and Mightier (msnbc)
State-run funds are now far richer and more powerful than hedge funds, with vast implications for global markets.

July 16, 2007 issue - China is putting its surplus billions to work, in what is effectively the official state hedge fund. Beijing is set to inject some $200 billion into a new sovereign-wealth fund for investment abroad in assets including stocks, real estate and commodities—anything that earns the government greater returns than the money its central bank has parked in U.S. Treasury bills. And that's just the opening gambit. Stephen Green, chief economist for Standard Chartered Bank in Shanghai, expects China to channel an additional $100 billion or more into the fund in 2008, with further infusions if all goes well in year one. Initially, he says, in-house fund managers will tread softly. "[But] once they feel they have the hang of it, they'll get more adventurous. At this point it's toes in the water."
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Not all those toes are Chinese, either. Over the past three years the list of sovereign funds has grown, and now includes Russia, South Korea, Australia and many others. Already such funds control an estimated $2.5 trillion in assets, some $1 trillion more than all hedge funds combined, and Morgan Stanley recently estimated that they could balloon to $12 trillion within a decade to become the dominant force in global finance.

The money comes mainly from oil-exporting nations flush with petrodollars, and East Asian governments struggling to cope with massive trade surpluses. A third driver—national pension funds—is gaining power. Most funds have the same goal: "higher returns earned by taking greater risk," says Kim Young, head of planning for the Korea Investment Corp. (KIC) in Seoul, which launched its sovereign-wealth fund in 2005.

Sovereign wealth represents a powerful new player. In the past, governments were satisfied with the nominal returns that their central banks delivered, which left hedge and mutual funds to battle among themselves in emerging markets, new technology sectors or whatever else looked hot. With sovereign money now in the fray, many analysts expect further asset inflation in stocks, commodities and real estate. And because these funds fly flags and serve strategic national interests, every move they make will attract scrutiny, much as China's state enterprises do whenever they acquire a foreign rival. "Political risk is one challenge," says Grace Ng, a Hong Kong-based Greater China economist at JPMorgan, in reference to China's new fund.

The lack of transparency at virtually every sovereign-wealth fund (Norway's being the lone exception) only heightens suspicions. Last week investment guru Nicholas Vardy called them "secret societies that make hedge funds yesterday's news" and warned that tracking their activities is "nearly impossible." IMF chief economist Simon Johnson recently described sovereign funds as "black boxes," adding: "We don't know what happens [inside them], and we should worry about that." His concerns include the possibility of rogue trading, currency speculation and excessive lending leading to a sovereign default.

Singapore is the model for sovereign-wealth management. Its Government of Singapore Investment Corp. (GIC), which oversees the city-state's reserves, and the Finance Ministry's investment arm, Temasek, together control more than $180 billion in assets. By comparison, Goldman Sachs Asset Management is valued at $33 billion and Blackstone, the largest private equity fund, has $80 billion in assets under management. The GIC acts as a national pension fund, but has earned roughly double the 4 percent that central banks traditionally do when managing foreign reserves. Temasek, which began an aggressive acquisition drive in Asia four years ago, has earned average annual returns of 18 percent since its inception in 1974. But it has also ruffled nationalist feathers abroad, most notably in Thailand, where its purchase of the media conglomerate Shin Corp. from the country's then prime minister precipitated a political crisis that led to Thaksin Shinawatra's ouster in a bloodless coup last September.

Still, matching Singapore's performance won't be easy. "The bottom line," says Donghyun Park, a senior economist at the Asian Development Bank, "is the would-be Temaseks and GICs are still very much in the learning stages." At the KIC in Seoul, caution is the watchword. It has invested just $8 billion of the $20 billion pledged, all of that into fixed-income investments in the United States, Euroland and Japan, as required by the government.

Most sovereign funds have objectives beyond profit maximization. For years oil exporters the United Arab Emirates, Saudi Arabia, Norway, Kuwait and the State of Alaska have used them to weather periods of low energy prices, for example. The KIC aims in part to promote Seoul as a regional financial hub by luring in outside fund managers, investment banks and financial talent, while training Koreans with similar skills. Korean officials have also indicated that in the future, KIC might be allowed to tap the nation's $200 billion state pension fund, which in "exceptional situations" plans to assist major domestic companies fend off hostile takeovers. The rub: if KIC is linked to protectionism at home, it is likely to encounter retaliation when it shops for assets abroad.

If recent history is any indication, China's new fund is in for intense scrutiny. Analysts expect China will shop for energy, industrial resources and emerging-market stocks to shares in American blue chips like Microsoft and GE. Already, a backlash is brewing. When U.S. private-equity fund Blackstone announced last month that China had purchased a $3 billion stake ahead of the fund's planned IPO, Washington pundits and politicians quickly denounced the linkup. Virginia Sen. Jim Webb called on the U.S. Treasury Department to review a deal that grants China "opportunity for undue influence," as he put it.

Other sovereign-wealth-fund managers are watching the China-Blackstone deal as a test of whether risk-averse state money and high-flying hedge funds can partner successfully. Already the bloom is off. Blackstone has faltered since its IPO in June. Its share price has dropped below what China paid, and on paper the deal has cost Beijing a loss of $3 million. That's one toe that got a little burned.

BANG WALLOP

When the crash happens, one man is waiting to pick up the pieces (times)
After enduring frustration in politics, Archie Norman is driving his Aurigo vehicle in a market he believes is at the top

Archie Norman had been suffering from a severe case of twitchy fingers. Since the launch of Aurigo, his investment vehicle, 18 months ago, the man who rescued the Asda supermarket group from near-bankruptcy in the 1990s had tried and failed to buy companies including Phones4U, the mobile phones retailer, Esporta, the fitness chain, Focus, the DIY group, and most recently Brakes, the food distributor.

“If, like me, what you're interested in is management and you don't have a business to manage, that's frustrating,” Mr Norman says of the delay in securing Aurigo's first buy. “I have had 18 months with my fingers twitching.”

His waiting is over, however, because Aurigo - from the Latin for “to drive a chariot” - is starting to bed down its first acquisition. The investment vehicle that he set up to “reorganise and reshape businesses to deliver fantastic value for customers” and Och-Ziff, the hedge fund, have bought HSS, the tool-hire company, for £310 million.

Mr Norman insists that “just one more” deal in the next year would be fine for Aurigo. “We're very cautious,” he says. “We think it's the top of the market at the moment, but it's a long top. As a result, we are very conservative about the way we invest. But I am not going to sit on my backside for the next five years waiting for the top to come off.”

Although the market has got hotter since Aurigo was established, Mr Norman predicts that it will “inevitably” crash at some point. “I don't think it's going to last,” he says. “I think there is going to be blood on the streets. We are not going to rush into anything. I bear responsibility for the people backing me to make good use of their money.”

Mr Norman, the son of doctors and educated at Charterhouse, Cambridge and Harvard Business School, has experienced rapid rises in business and politics. The former Conservative MP for Tunbridge Wells began his career in banking before joining McKinsey, in which he was made the youngest partner at 28. He became finance director of Kingfisher, then Britain's biggest retailer, at 32 after helping Sir Geoff Mulcahy to defend it against a bid by Dixons. Five years later he became chief executive.

He made his name with the turnaround of Asda, which was broken when he joined it in 1991 and which he sold to WalMart eight years on for £1.6 billion, having made it Britain's second-biggest supermarket chain.

He went on to orchestrate a revival of Energis from administration, gaining the lion's share of a bonus pool of £30 million when the telecoms group was sold to Cable & Wireless in 2005.

Although acutely aware of the pitfalls and costs of turnarounds - he cut 5,000 jobs at Asda (a “miserable” experience) and sold some prime stores to cut debt - Mr Norman relishes the challenge of a rescue. “We are very happy to take on situations that are troubled,” he says of his brief in Aurigo. “Nobody likes trouble. It's much better to buy a Rolls-Royce than a clapped-out old banger and rebuild it. But you often create the greatest value out of taking situations that other investors find toxic.”

Mr Norman entered the Commons in 1997 as a Conservative moderniser and backed his former McKinsey colleague William Hague for the party leadership. He was made vice-chairman with responsibility for the party's reform, but expertise at restoring languishing businesses did not convert easily to the political arena.

“I spent eight years in the Conservative Party as an out-and-out reformer trying to convince my colleagues to turn and face the electorate and to set on one side nostrums of the past and recognise that the face of British politics had changed,” Mr Norman says.

“We didn't make much progress in those eight years and so, to me, David Cameron is a sort of a miracle. I didn't see him coming. I think he understands what the party needs to do and where it needs to go. He has made more progress in two years than we made in eight years. People underestimate what a hard thing that is to do in the teeth of a culture that was not welcoming of change.”

Politics left its mark on the businessman, who says: “Business and politics are a world apart in culture and attitude - and probably more so today then ever. Politics has become professionalised and there are few avenues for business people to engage in public life. It's no good as a successful businessman thinking you can swan into politics without learning the arts and crafts of Westminster; it is a different world. There is a huge contribution that business people can make to public life and a huge contribution that political people can make to business life, but because the two have grown apart, they treat each other with a degree of disdain which is very unfortunate. It's rather a British thing.”

Although he maintains an interest in public policy - he set up C-Change, a think-tank for modernisation, and Policy Exchange, an independent research body - Mr Norman's attention is focused entirely on Aurigo.

“Our philosophy is: what you buy, you buy for life,” he says. “If we aren't prepared to own it for ten years or more, then it's not for us. Real management change needs time and a long-term commitment. One of the problems of the financial community is that it systemically underrates management and the value that great management can deliver for shareholders, and systemically overrates buying low and selling high.”

He says that what drives him is the belief that “work is an important part of people's lives” and that creating the right environment will produce a “stunning” management team and a great work environment, allowing a business to create value, year after year. “I think people come to work to shine and it is our job to make them shine,” he says. “And that's not just some happy-clappy philosophy. That is what I think is at the core of value-creation in service industries.”

Part of Mr Norman's management strength is his ability to spot and build strong leaders. Former Asda colleagues include Allan Leighton, now Royal Mail chairman, Richard Baker, chief executive of Alliance Boots, and Andy Hornby, head of HBOS. Justin King, head of Sainsbury's, and Andy Bond, who now runs Asda, are further examples.

“It makes me feel a bit like granddad,” Mr Norman says, beaming at the success of his protégés. “We didn't go out and hire superstars. We hired people no one had ever heard of, but they were smart people and they liked working our way. They fit in with our attitude and culture and took that to other companies.” On private equity, Mr Norman believes that the sector's rise to owning a big slice of British business is creating a need for it to behave “like public equity”.

Although reluctant to predict when the market will come off the top, he cites hubris as a factor in a build-up of systemic risk that will amplify the impact of a crash: “People tend to believe they are great investors because they made a great return in a rising market. Many of this generation of financiers have not experienced a crisis, a recession, for many, many years and so they are not prepared.” If a crash comes, Mr Norman will be ready, fingers twitching, to pick up the pieces.

The leader questioned

If you could change one thing in the financial and commercial environment, what would it be?
It sounds very earnest, but it's an appreciation that business and investment value is created by good management. And understand that good management is extremely difficult to cultivate and develop. Britain has become a very transactional place. The immense success of the financial services industry, private equity, hedge funds etc means that smart young people feel that's the place to work. The culture has become about transactions and about financial engineering, when underlying it all is the real mission to find real people. The long-term value you create depends on them, so how you manage them is what we, as a country, should be worrying about.

What does leadership mean to you?
Leadership is about unleashing the potential of the people who work for you and to make them feel that, ultimately, they did it.

Which businessman or woman do you most admire?
That's a silly question.

Who is or was your mentor?
It's a fashionable thing to have. People write management books on mentors, so you are supposed to have one, but it doesn't really work like that in practice. I have worked with lots of super people. At McKinsey, Geoff Mulcahy is a wonderful guy, a super, super businessman. I learnt a great deal from the people who worked in my team at Asda; Allan Leighton was a terrific manager. John Pluthero, whom I hired as chief executive at Energis, is a great manager. Part of it is that, as you grow more experienced at business, it's a struggle to figure out every day that you still have as much to learn as when you started. That's got to be your attitude. Otherwise you become, as we all recognise, a sort of crusty chairman who thinks he has seen it all and has axioms of management. Its dangerous to have axioms as there is no dogma in management and every company is different.

Which is more important: what you know or who you know?
I am not an establishment sort of networker, but there are plenty roles - headhunting, for instance - where it's probably extremely important to know a lot of people and be able to pull in favours. Knowing people is not enough; you have to have their respect. You get respect for what you do, and what you do is what you know. I don't mind what people think of me, but I mind very much that I have their respect and they understand what I'm trying to do.

Does money motivate you?
No. By today's popular standards I am not immensely wealthy, although I have made some money and I am very glad of that. But if I never earn any money that doesn't worry me, I can go and cut down trees somewhere. I am really interested in creating organisations that are doing something good for the people working for them and their customers. If you do that, and if you have the right economic model, you will generate value. And if you generate value, people will pay you money, but it has got to be that way round. Those who set out first and foremost to make money and then worry about how they are going to do it are putting the cart before the horse.

What is the most important business event, good or bad, to happen in your working life?
I think turning up on a rainy day in December 1991 in Leeds to join a completely broken business, with no real understanding that the only reason I got the job was that there were no other applicants.

What gadget must you have?
I am happy to be gadget-free, but I'm not a technophobe. I have an iPod and a mobile phone, I use my laptop, I'm on e-mail and have a BlackBerry. But if you took it all away it wouldn't worry me. In Scotland we have no television. We have no central heating, either, but that's another story.

How do you relax?
When things are going well at work I find that quite relaxing. We have horses, the dogs, I have my farm in Scotland and I am happy to be away from people.

C.V.

Born: May 1, 1954, Surrey
Education: Charterhouse; University of Minnesota; Emmanuel College, Cambridge (MA Economics); Harvard Business School (MBA)
Career:
1975: Citigroup.
1979-86: McKinsey & Co.
1986: finance director, Kingfisher.
1991: CEO and later chairman, Asda.
1997: Tory MP for Tunbridge Wells, standing down in 2005.
2002: chairman, Energis
Personal: Married with one daughter

HONKERS

HKMA Chief Worried About Risks Posed By Hedge Funds, (investorsoffshore)
Hong Kong Monetary Authority chief Joseph Yam has said that while hedge funds bring benefits to the financial markets, the current regulatory framework may not be robust enough to remove systemic risks to the global financial system posed by hedge fund activities.

Writing in his latest 'Viewpoint' column, Yam warned that although the hedge fund industry has evolved over the past decade since the Asian financial crisis, which he said was triggered by "a group of aggressive hedge funds", there remain concerns about hedge fund activities in the region.

"Hedge funds can bring significant benefits to financial markets, but they also bring with them the possibility of systemic risks," he observed. "On the positive side, hedge funds help provide additional liquidity to financial markets and improve market efficiency by taking risks to exploit arbitrage opportunities. They also facilitate financial innovation by participating actively in developing and trading complex and innovative financial products, such as credit derivatives. The greater risk appetite of hedge funds increases the overall risk-taking capacity of the global financial system, while their "contrarian" investment style tends to stabilise financial markets by maintaining liquidity during sharp declines in asset prices."

However, Yam went on to caution that: "Despite all these benefits, hedge funds also raise concerns about significant systemic risk, and these concerns are growing along with the increasing asset size of hedge funds and their share of turnover in various markets. Hedge funds now account for roughly 40% of the turnover of major stock exchanges, a quarter of credit derivatives turnover, and around one-quarter of high-yield bond holdings."

Yam believes that systemic risk is most likely to arise from the failure of a significant hedge fund that has large exposures to other financial institutions.

"The failure itself, and any panic sell-off afterwards, could push up the risk premium, causing a sharp decline in asset prices that might eventually drain the market of liquidity. It might also trigger herding behaviour among some less sophisticated hedge funds," he wrote. "Too many one-way bets could create excessively concentrated positions, which would make the financial system more vulnerable to sudden market shocks and disorderly exits."

Yam added:

"The potential systemic risk from hedge funds is further amplified by their unstable capital base, which is likely to shrink quickly in times of stress either because of redemption by the investors or the funds' leverage ratio being too high. The latter problem is becoming more acute, because it is difficult to accurately measure the embedded leverage in complex structured products."

The HKMA chief noted that hedge funds also present new challenges to regulators, since most hedge funds fall outside of national regulatory regimes.

"It is very difficult to bring them under proper regulation because they can easily relocate to a jurisdiction with lesser regulatory requirements. What makes the oversight of hedge funds so difficult is that care needs to be taken to avoid stifling the creativity and innovation in financial products they bring about. The goal is to harness the benefits of having the hedge funds in financial markets while building sufficient safeguards to address the systemic risk they create. This is no easy task," Yam observed.

Hedge funds are also fundamentally changing the structure of the international financial system, suggested Yam. "As Governor Noyer of Banque de France put it, market dynamics are now increasingly disassociated from banking intermediation."

"We have seen large-scale transfer of credit risk from the banking sector to hedge funds through securitisation and the use of credit derivatives. The fact that banks no longer need to bear the ultimate credit risk may weaken their incentives to lend money more prudently, sometimes leading to an erosion of credit standards. But the hedge funds, which are the ultimate risk bearers, may not have sufficient information about the underlying credit risk of the structured instruments they have bought," Yam wrote.

This issue has been highlighted by the recent failure of the two hedge funds run by Bear Stearns which specialised in investing in collateralised debt obligations with sub-prime mortgage loans as underlying collateral, according to the HKMA chief.

"While credit rating agencies may be able to fill this information gap, credit risk may still be mis-priced," he wrote, continuing: "In facing these challenges, most regulators choose to manage the systemic risk of hedge funds through the regulation of their counterparties, mostly banks and securities firms. This indirect oversight approach is desirable because it preserves the incentive for hedge funds to promote financial innovations. It is also a more pragmatic approach given how hard it is to subject hedge funds to direct regulation."

He concluded: "Nonetheless, there are still some questions about whether the current approach of indirect oversight is adequate to address the systemic risk of hedge funds."

CARBON FOOTPRINT

Dubai Issues Draft Hedge Fund Code (tax-news)
The Dubai Financial Services Authority (DFSA) last week issued a draft Hedge Fund Code for public comment. The Code builds upon the legal requirements applicable to all Collective Investment Funds in the Dubai International Financial Centre (DIFC).

LOADSAMONEY

Private equity versus hedge funds (ft)
Hedge funds and private equity have one big thing in common. Both charge whopping fees - typically 2 per cent of assets under management (AUM) and 20 per cent of investment profits. Otherwise, the differences are huge.

Private equity is a heavily geared, “long-only” investment in illiquid assets (whole companies), with high levels of control and a multi-year time horizon. Hedge funds, by contrast, typically invest in liquid securities, with no control. They have the flexibility to take both long and short positions and their performance, because it is more transparent, is judged almost constantly by investors.

So which of the two asset classes is more valuable when a management company goes public? The obvious answer is private equity.

First, assets are tied up long-term. Kohlberg Kravis Roberts, which plans an initial public offering, says 73 per cent of its assets are committed for as much as 18 years. While KKR is highly unlikely to hold any investment for that long, it does give huge flexibility to ride out tough times. And it provides a steady stream of cash from the 2 per cent management fee - alongside the bigger and more volatile 20 per cent share of investment gains. Private equity funds also juice fees with a charge for each deal they do and sometimes a cut for syndicating equity to third-party investors. That can take underlying management fees closer to 3 per cent.

By contrast, hedge fund investors can pull their money quickly if performance is bad, making the underlying fee stream less secure. In addition, poor investment returns can quickly inflict a double whammy on a hedge fund manager's earnings - of weak performance fees and falling AUM as investors withdraw money.

Second, private equity firms feel more solid. They have established brands such as Blackstone and KKR, they buy full control of businesses people know, and buy-outs have largely avoided financial trouble in recent years. Hedge funds, for some, conjure up images of whizz-kids rolling the dice on behalf of clients, leading to high-profile blow-ups such as Amaranth and recently some mortgage funds at Bear Stearns.

Finally, private equity firms have a “cookie jar” of unrealised gains on their illiquid investments that should emerge as cash flow when the businesses are sold. (At least, that is the case in today's strong market.)

But dig a little deeper and hedge funds also have their charms. They mostly lack the protection of long lock-ups. But in good times their AUM grows naturally because, unlike private equity, they do not constantly hand cash back to investors when they exit investments.

Hedge funds are more geared to good performance. If they generate strong returns they enjoy handsome performance fees. The assets on which they can charge future fees also grow by that amount and the good performance attracts further inflows.

In the end, both models live and die by their returns. Private equity groups have longer to prove themselves, have real control over their portfolio companies and can ride out most market storms. Hedge fund investors, meanwhile, can see the real performance each month because most securities are listed. If that is bad, it can spark a rush to the exit and cause real problems for the management company.

Fortress and Blackstone, the main US companies already public, have a mix of other assets alongside their straight private equity funds. The coming IPOs of Och-Ziff, a pure hedge fund, and KKR, a pretty pure private equity manager, should give a clearer idea of relative valuations. Assuming hedge funds do not lengthen lock-ups significantly, private equity should usually command a higher multiple.

However, investors also need to take cycles into account. The easy credit conditions that have fuelled the private equity boom are showing signs of strain and stocks are well into a long bull market. The flexibility of hedge funds to go short and mix up the assets they invest in might make the most blue chip managers look attractive in tougher times.