The New Year will see larger hedge funds and private equity businesses voluntarily submit themselves to increasing oversight, Paul Smith expects, with unfortunate consequences for smaller players

As is traditional, it is time to take a long look at the direction our industry is headed and to make some predictions for the 12 months to come; all of which, mercifully, will be forgotten in a year's time!

Next year promises to be a watershed year as many of the larger, global players in the hedge fund industry finally decide to move into the mainstream. The implications of this are far-reaching, and potentially damaging, to many of the current players in the hedge fund world.

This year has been quite a year for the alternative industry. The sub-prime woes have carried many out feet-first and led to opportunities for others. Hedge funds again have been an easy target for regulators, bankers and politicians to blame for their own inadequacies.

The assault on the activities and compensation arrangements of the private equity industry has also made many hedge fund operators think hard about their own public image. The high-profile listings of groups like Fortress and Blackstone have added fuel to that fire, again highlighting just how wealthy some hedge fund practitioners have become.

If you are a large manager (over $5bn) and especially if you want to become larger, the comforting embrace of the regulator looks a better and better option for deflecting some of this criticism and provide you with an umbrella under which you can continue to build your business. This is inevitable as larger managers increasingly find their businesses driven more by asset gathering than by performance. If you are running over $5bn in assets, what else can you do?

There are a few interesting straws in the wind that bear looking at in this regard. First, and perhaps most worryingly, is the report of the UK-based Hedge Fund Working
Group (HFWG), chaired by Sir Andrew Large, which was published in draft in October. Responses from the industry were due in by mid-December and the final report is to be published in January. If there are any hedge fund practitioners out there who haven't read this report, please do so -

The HFWG is a loose association of about 20 of the largest London-based hedge fund managers, which are responding to the pressures they feel the industry is under from regulators and from government. They have chosen to act independently from the Alternative Investment Management Association (AIMA), whose views and past work they acknowledge and borrow from, but who they clearly feel cannot best represent their interests.

AIMA is a trade association that works for managers both large and small, as well as for service providers, and primarily tries to foster education in and about the industry globally. The HFWG proposes a set of guidelines and best practice rules that mostly replicate AIMA's but, interestingly, it also proposes the establishment of a board of trustees to oversee these rules that would be composed of members of the larger hedge fund groups.

It is unclear at this stage what status and authority this body would have with the UK regulator. If you are a smaller manager, it is a very worrying development. There is little doubt that the HFWG is an advocate of greater regulation and oversight of managers and that this, in turn, will raise the barriers to entry to the industry. It is a small but very definite step along the way to taking the industry into the mainstream.

The fact that the board of trustees will be composed of the larger managers lends an added layer to this concern as does the fact that they have felt the need to form a body outside of AIMA's control. AIMA has always tried to pursue a more broadly-based agenda. (I must declare an interest here, I am a past member of AIMA's global council and am still a council member in Hong Kong of the local chapter.)

The other weighty tome published recently that you should look at if you can is the Mckinsey Global Institute's October report, The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity are Shaping Global Capital Markets. With such a snappy title to go with its 175 pages of text, it's not to be taken lightly in any sense but is a rattling good Christmas/New Year read for that someone special.

I haven't the space here to do the report justice, but two of the chapter headings will give you all the flavour you need. Chapter 4 is entitled "Hedge Funds: from mavericks to mainstream" and Chapter 5 "Private Equity: Eclipsing public capital markets". This report leaves one in no doubt why regulators and governments are so keen to extend their influence and understanding over the alternative world, whose capital now dominates so many of the key pressure points in the global financial system. From their perspective these unregulated pools, driven solely by profit, can and do disrupt their best-laid plans.

The New Year will see this dynamic play itself out. The larger hedge funds and private equity businesses globally will voluntarily submit themselves to increasing oversight. The unfortunate consequence of this is that the smaller groups will be brought unnecessarily into the regulators' spotlight. Costs of operation will inevitably increase, some marginal businesses will fold and returns to investors will decline. The cycle will repeat itself as some managers will find new ways of escaping the regulatory dragnet and begin to form the alternative industry of tomorrow.

Paul Smith is chief executive officer of Triple A Partners based in Hong Kong