THERE is nothing quite so cool as a hedge fund manager. With huge commissions (typically 20 per cent) and a trademark agility in making quick entrances and finely timed exits, they have become a magnet for investors who want to share in their success. “They are the ultimate non-long-term investors,” Jonathan Bayliss, of Farrer & Co, says.

Yet, according to some observers, not all is as it seems in Hedge Land.

The slim, agile hedge funds of a few years ago are starting to mature into rather bloated adolescence. “The golden age of hedge fund profitability ended some time ago,” Simon Gleeson, a banking partner at Allen & Overy, says. And whereas one of the joys of hedge funds was their apparent light regulation, those days too may be numbered.

A discussion paper published by the Financial Services Authority (FSA) last month analysed the risks in the hedge market and initiated a consultation exercise (to be completed in the autumn) of how they should be addressed. “The most likely outcome is that the FSA will follow the US Securities and Exchange Commission in introducing further regulation,” Gleeson says.

“Meanwhile, the funds themselves have become so big and there are so many of them that they are acting in a more mainstream way.”

Not everyone, it must be said, accepts this view. The two top firms in hedge fund work in London are, probably, Dechert and Simmons & Simmons.

Peter Astleford, joint head of Dechert’s global financial services practice, says that we are only at the start of (what he predicts) will be a long and glorious era of hedge fund activity as increasing numbers of investors recognise that the established “long-only” market will be consistently outperformed by the “absolute return strategies” of hedge funds. “It is still not widely understood, especially in the legal world, just how active and vibrant this field is,” he declares with the confidence of a man heading a team of 25 specialists.

The image of hedge funds being out of control, operating from “pirate island”, is also firmly refuted by Astleford. In terms of professional qualifications, anti-money laundering and a range of other key controls, he argues that London is already far more sophisticated than the US. Nonetheless, the debate opened up by the FSA’s discussion paper could go either way.

Astleford’s view is that it would make more sense for the FSA to focus its concentration on the activities of the giant prime brokers rather than the comparatively small hedge funds. And he is encouraged that the FSA did not opt immediately for the “knee-jerk reaction” of more regulation. “The fact is that the average hedge fund manager is very conservative because his remuneration is based on achieving success for his clients.”

The select group of lawyers working in this field — only a dozen firms are significantly involved — are doing well out of hedge funds because they play a key role at every stage in their life cycle. While the success of a fund will depend on the analytical skills and gut instincts of its managers (“mostly high-octane personalities”, as one lawyer described them), the legal design of the vehicle is of critical importance.

“We became involved in hedge fund work because we give a lot of advice on start-up operations,” Jonathan Bayliss says. “They are all based offshore for tax reasons — normally in the Cayman Islands — and they need lawyers to advise them on the regulatory and tax issues as well as to provide project management once they are under way.”

So while the funds are located offshore — with accompanying benefits in tax terms — this does not exempt them from normal English law, nor FSA oversight. Rather than being lawless, the funds actually use the law very creatively. Or, as the FSA puts it, they have “dispersed and complex legal structures” and some of the risks associated with them derive from “the complex legal structures . . . that often involve operations in offshore tax havens”.

Although many funds have a common basic structure, the real difference lies in defining their investment strategy, Simon Atiyah, of Lovells, says. So lawyers have the key role in preparing and reviewing the fund’s prospectus and setting up the offshore and onshore funds and investment management vehicles.

Once the funds are established, prudent managers will be on the phone regularly to their legal advisers to ensure that they are not exposing themselves to any accusation of insider dealing or market abuse. Because many investment decisions have to be taken at very short notice, the advice often has to be given very quickly. “It can be a fairly hectic part of our lives,” Atiyah says. “There are lots of grey areas — especially in relation to derivative instruments — which is why managers who are risk-averse will contact us every time there is the chance of overstepping the mark.”

The problem is that the mark is in the sand — and that is constantly being blown about. In a close-knit business where lots of people know each other well, it is inevitable that gossip, rumours and hard facts are being exchanged all the time. To act on what is seen to be insider information could be devastating — but proving that an investment decision emerged, in fact, from solid research can be difficult in the absence of a paper trail. “That is exactly why I think that greater reporting requirements will be introduced,” Bayliss says.

Hedge funds are here to stay. But just how free and unfettered they will be allowed to remain is now a matter of intense speculation.

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