Graham Phillips and Jerry Dawson of PricewaterhouseCoopers, London provide an overview of key developments across the European hedge fund market.


Developments in the European hedge fund marketplace are continuing apace in a virtual circle comprising the following: Investors understanding of hedge funds rises; Increasing awareness of risk of capital loss; Increasing demand for wealth protection products that can generate alpha; Manufacturers respond with product solutions that utilize hedge fund techniques; Investors increasingly in hedge funds or products using hedge fund techniques; Regulators respond appropriately.


• Stock market crashes of recent years have focused investors' minds on the lack of capital protection offered by many traditional investment products, with an increasing awareness of the concept of "alpha" and the potential for achieving positive returns together with capital preservation.


• As manufacturers seek to develop products that offer investors solutions to their investment needs, hedge fund investment and risk management techniques are increasingly forming part of the mainstream investment management process, although the "hedge fund" label is often absent from the resulting products.


• This blurring of the boundaries between traditional and hedge fund products has caused regulators to acknowledge that the penetration of hedge fund styles is unstoppable, and regulators are accepting that hedge fund techniques can be appropriate for "mass affluent" and/or retail investors.


Interestingly, discussion has commenced at a European level on the possibility of creating a pan-European regulatory regime to accommodate alternative investment vehicles such as hedge funds.


However, despite these moves, national regulators have different appetites for changing their existing rules. Fiscal authorities, with the notable exception of Germany, have generally been less quick to respond than product manufacturers and regulators.


Regulation is typically less well-developed in the ten EU accession countries, and with fewer old rules to unscramble, regulators may have greater flexibility in determining appropriate regulatory frameworks.


Administrators setting up in these countries are likely to be cost-competitive and, with the ability to embrace the latest technology, they are in a strong position to challenge the existing traditional centres for hedge fund administration.


The US is moving towards the European model of closer regulation of hedge fund managers, with larger managers soon likely to be required to register with the SEC.


Regulation in the traditional offshore "tax havens" is also tightening, partly as a competitive response to onshore regulatory developments and also in connection with managing their reputations as territories that are fully supportive of global efforts to fight the proceeds of crime.


The hedge fund industry must continue to use its influence to shape the future regulatory environment and hence the destiny of the industry in Europe. An appropriate and flexible regulatory regime remains vital for competitiveness with the US and increasingly Asia, so it is paramount that the inevitable rule changes are not imposed by regulators without consultation with the industry.


Industry initiatives, such as the development of "Sound Practices" guidance, and participation in dialogue with regulators through industry associations, demonstrate that the industry takes its profile seriously.


Looking forward, the industry should consider setting voluntary standards in such areas as valuations and fund corporate governance to supplement the increasing oversight of operational risk management by European regulators.


This article was prepared by Graham Phillips (Tel: 44 20 7213 1719) and Jerry Dawson (Tel: 44 20 7804 2624) of PricewaterhouseCoopers, London.


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