Hedge Funds and Conflict Of Interest

Hedge funds are often looked upon as being unethical in their practices. This is partly because there is public outrage about the amount of money that some of the fund managers are able to earn as income even though they are supposedly causing systemic crisis. The fact that the names of hedge fund managers have come up in several scandals further accentuates this negative perception. In this article we will have a look at how hedge funds take care of their fiduciary duties. We will also look at some examples of possible conflicts of interest for the hedge funds.

Fiduciary Duty

Each and every hedge fund has a fiduciary duty towards its investors. This means that it is supposed to disclose all material and relevant information which may harm the interests of the investors putting their money in these funds. Therefore, even though hedge funds do not fall under the purview of most laws pertaining to investment securities, they can still be prosecuted for hiding information. Such hiding of information amounts to misrepresentation in a contract.

Cases wherein investors have been cheated by the hedge fund management have been reportedly presented for trial in the American judiciary system. Some of the common conflicts of interest are as follows:

Examples:

• Side Letters: Sometimes hedge funds want big investors who can invest significant sums of money. Although, all investments in hedge funds are huge by normal standards, the management may still want more money from let’s say another hedge fund. In such case, it is likely that they may grant concessional terms to these big investors. For instance a fund of funds may only be willing to invest in a hedge fund if it is given liquidity preference. This means that this fund will be allowed to withdraw its investments at a short notice and possibly at a lower cost than the other investors. They may also demand certain additional privileges like the first right to make additional investments but not the obligations to do so. Sometimes they may be given access to information which is not given to the average investor like trade books etc.

  The point is that this arrangement puts one investor or group of investors at a significant advantage compared to the other groups. This is called a “side letter” and should not be done secretly and without the consent of other investors. Hedge funds are required by law to disclose such conflicts of interest to potential investors.

• Side Pockets: Hedge funds sometimes take money for investors for a shorter period of time. However, this money is illiquid and cannot be redeemed for a fixed amount of time. In practice it is like a fixed deposit made to a hedge fund. In industry jargon this is called a side pocket and is used by the hedge funds to make investments that are illiquid and difficult to value. Hedge funds are expected to disclose these side pockets to potential investors. Also, they are not supposed to project the return generated on these assets to potential investors as usual performance.

• Simultaneous Management: Hedge funds managers are like celebrities in the financial world. Once they create a good track record, they are extremely sought after. It is possible that some hedge fund managers may be working on more than one investment portfolio at a given time. This situation must be disclosed to the investors with immediate effect. This is because a hedge fund manager can artificially inflate his performance if he is in charge of two portfolios. He can do so by cross trading between them. Therefore to increase the ROI of the portfolio, the manager may sell from one portfolio and buy from another one at an inflated price. This is likely to have an adverse effect on one group of investors while having a favorable effect on the other group.

• Insider Trading: Hedge funds are also notorious for insider trading. Since they have access to such huge sums of cash and do not need to disclose information, they sometimes become the pawns used by corrupt promoters to benefit themselves at the expense of other shareholders. No amount of disclosure can solve the problem of insider trading. However hedge funds must ensure that they do not take money from high risk as well as prohibited investors.

• Prime Commissions: Commissions are a legitimate operating expense of the business. However, salaries and rents are overheads. There is a huge difference between overheads and operating expenses and SEC is very particular about it. Some hedge funds have tried to include a percentage of their overheads into commissions paid to the prime broker. However, the SEC has been very vigilant about this fact and has levied penalties whenever such a case has come to light. Hedge funds are required to stay away from such deceptive practices failing which they are misleading the investors and therefore are in a conflict of interest situation.

It would be fair to say that hedge funds as an industry are victims to the perception that has been created by some unethical managers. More often than not, hedge funds are run in a perfectly legal and ethical way. However, the occasional news article creates a bigger impression on the minds of the general population and the entire industry gets a bad name.