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Hennessee backs tightening of hedge fund investor criteria

Hennessee Group, an adviser to hedge fund investors and provider of hedge fund indices, has thrown its support behind the tightening of requirements for accredited hedge fund investors proposed by the US financial regulator, the Securities and Exchange Commission.

The firm's managing principal, Charles Gradante, also applauds the so-called 'gatekeeper' approach adopted by the US authorities to carry out indirect monitoring of potential systemic risk arising from the hedge fund industry through co-ordination with advisers, service providers and counterparties that are in many cases themselves subject to regulatory oversight.

Says Gradante: 'The increase in personal household wealth, inflation and economic growth since 1982, when the accredited investor level was enacted, of itself points to the need to increase the accredited investor level. Additionally, the Hennessee Group also supports the 'gatekeeper' approach to monitoring systemic risk and enhancing investor protection.'

Gradante says that interaction between regulators and gatekeepers such as prime brokers, accountants, administrators, investment banks and commercial banks can be a cost-effective alternative to direct regulation of hedge fund managers, which was introduced last year by the SEC but thrown out following a court challenge.

According to Hennessee Group research, the largest 100 hedge funds account for more than 50 per cent of the industry's total assets and represent the most likely root of systemic risk. 'The 100 largest hedge funds should be given the equivalent of 'CUSIP numbers' to track their activity through prime brokers and commercial banks, who in turn would report data to regulators, the Treasury, and the Fed,' Gradante says.

'This would allow significant transparency into the use of leverage and potential systemic risk.' Most hedge fund leverage comes from two sources, investment banks and commercial banks, both of which are regulated and can report leverage to regulators and government agencies.

According to Hennessee Group, more than 90 per cent of US hedge funds currently use one of 10 prime brokers who are registered broker-dealers and are regulated by the SEC and the National Association of Securities Dealers, from whom information about leverage and concentration can be gathered.

Gradante says that in order to boost investor protection, the authorities should seek through best practice or regulatory means independent calculation of net asset values for domestic hedge funds by third-party administrators on a monthly or quarterly basis, and require accounting firms to send K-1 statements and annual audits directly to limited partners, rather than via the fund's general partner.

To establish a level playing field for all investors, including retail investors who want to invest in hedge funds, the mandate for the new class of mutual funds that are currently permitted to replicate a long/short managed fund should be broadened, Hennessee argues. In this way, retail investor would receive regulatory protection under the 1940 Investment Company Act while still enjoying the benefits of diversification.

The firm notes that more than 90 per cent of US hedge funds use one of six accounting firms to perform annual financial audits, while more than half of all US-managed offshore hedge funds currently use one of the top five administrators. Uncertainties about the size of the hedge fund industry, in terms of both assets and leverage, can be resolved by polling these firms, Hennessee says.

Gradante insists that by acquiring information from the gatekeepers, regulatory authorities and government agencies can gain insight into the hedge fund industry, which Hennessee values at USD1.442trn, in a cost-effective and timely manner without inhibiting the entrepreneurial spirit of an industry that provides liquidity, contrarian research and pricing efficiency to the markets.

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