Consolidation

Over recent years, the hedge fund industry has grown sharply and regulatory concerns about the industry have increased. In this section, we examine the implications of these developments for the industry. It is expected.

• The hedge fund industry as a whole will perform less well over the next ten years than over the last ten
• The hedge fund industry will become more institutionalized
• The hedge fund industry will become more regulated

These changes will reduce the gap between mutual funds and hedge funds, but not for all hedge funds. Some hedge funds will choose their investors and how they organize themselves so that they will be less affected by the increasing institutionalization and regulation of the industry.

As a hedge fund succeeds, it faces pressure to become essentially a diversified financial institution. To understand this pressure, consider a successful hedge fund manager who specialized in one strategy. The manager’s net worth is largely invested in the fund. The manager runs an organization with substantial fixed costs that has access to large-scale investors and that provides services to these investors.

To maximize the value of the assets the hedge fund manager has built—reputation, access to investors, organization—the manager can expand this organization through diversification. The hedge fund manager can start new products that rely on different strategies. The manager can also rely on reputation to sell products that are more similar to actively managed mutual funds.

In this way, the management company not only becomes more valuable, but it also develops a value that is independent of the initial hedge fund strategy employed by the manager. As hedge fund management companies evolve by expanding their range of products, they will behave more like financial institutions and less like single-strategy hedge funds.

Both Europe and the United States have experienced substantial pressure for increased regulation of hedge funds, for a number of reasons. Along with the systemic risk concerns and the investor protection concerns of regulators, mutual funds often lobby for more constraints on hedge funds. As more money is invested in hedge funds, managers have to branch out in new strategies, some of which may increase pressure for regulation of hedge funds. For example, over the last few years, more hedge funds have become activist investors. In some countries, such activism has led to demands for regulation.

Some hedge funds have also specialized in lending. Again, regulatory authorities are unlikely to allow unregulated hedge funds to compete with regulated banks. Recently, much concern has arisen from the fact that hedge funds borrow shares to vote in corporate control contests without bearing the risks of stock ownership. When a fund borrows shares and holds them to vote, it pays a fee to the lender, but the lender keeps the price risk of the shares. Regulations may be enacted to prevent such actions.

Hedge fund management companies compete with regulated financial institutions, regulated financial institutions seem certain to express concerns about the lack of a level playing field.

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