Market developments, including increasing availability of inexpensive credit, greater leverage of hedge funds and easier credit, have prompted Greenwich Associates to advise that hedge fund investors should prepare for more regulatory scrutiny of funds in the next few months. Additionally, the consulting firm suggests hedge funds should bolster risk controls and review practices. A Greenwich Associates survey of 36 hedge funds in the U.S., U.K. and Europe identified trends that could be a concern for current and potential hedge fund investors.

"In aggregate, however, these trends bear serious consideration on the part of hedge fund investors, not only as possible indicators of an ’overheated’ market, but also as potential harbingers of intervention by regulators in the United States and Europe," noted Greenwich Associates consultant Peter D’Amario in the report.

Competition among investment banks for prime brokerage business has contributed to the trends of easier credit and greater leverage. One-third of surveyed hedge funds noted they have increased their use of leverage in the past 12 months. Almost one-third of the funds have increased the number of prime brokers they used in the same time frame. The same number of hedge funds plans to add prime brokers in the next year. Questions remain on whether banks are being lax in giving credit to hedge funds and whether funds are implementing proper risk controls, noted the Greenwich Associates report.

Another factor in these developments is the increased participation of pension funds in hedge funds. The reporting hedge funds noted that on average, institutional investors account for over half of total business. In 2003, corporate defined-benefit pension funds allocated approximately $15 billion to hedge funds and public funds allocated $5 billion. Endowments and foundations in the U.S. allocated about $45 billion.

Greenwich Associates advises investors to stay on top of regulations and note that large and well-established hedge funds are more likely to have proper controls and procedures. Hedge funds should plan for possible increased review by expanding disclosure and re-assessing compensation and capital introduction practices. 

(InstitutionalInvestor.com)