Here we are, another year coming to a close. 2010 has truly been filled with uncertainty, anticipation and drama. Yet without all those elements, the hedge fund industry would not be the industry we know and love.
The year 2010 began with high expectations: raising capital was tough in 2009 and the hope was that 2010 would be better with billions of dollars on the sidelines, and new launches and start-ups being held as managers were looking for capital and a favourable time to launch. The Hedge Fund industry, in conjunction with the entire financial community, was speculating as to the potential for new regulations and their impact on the alternative space. And, as always, investors were worried about what 2010 would bring and the safety and security of their investments. Coming out of 2009 PIIGS were a concern, but bailouts were on the agenda for 2010.
In all, 2010 lived up to most expectations – the European Directive was approved in May and the US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was signed into law in July. The European Directive, while favouring Luxembourg and Ireland, was clearly a protectionist measure aimed at non EU jurisdictions. The European Directive’s effects on other offshore jurisdictions were at first unknown, and within a few months the US made clear its disapproval of the protectionist nature.
Fortunately, offshore jurisdictions such as Cayman, Bermuda, Bahamas, Isle of Man, Jersey, Guernsey and others went from being deeply concerned to accepting that the European Directive would not be as harmful as initially thought.
In the United States, most of the focus was on the Dodd-Frank legislation. The legislation, far from answering questions regarding registration requirements, created some uncertainties and will be working its way through the federal regulatory process for some time to come. In addition, states are scrambling to figure out how to regulate smaller managers. Many states previously relied on the federal government to oversee and regulate the investment management industry and are now called on to establish an oversight capability of their own. Clarity is needed on a number of fronts and the industry is hoping many questions will be answered in 2011.
Further “regulatory” action occurred at the end of November with the FBI raiding the offices of three large hedge funds as part of the “high profile insider trading investigation”. This is a second consecutive year that the hedge fund industry has been plagued with insider trading allegations.
On a positive and quantitative note, as 2010 comes to an end it is estimated that the industry has regained the $2 trillion mark of assets under management.
Even though it appears the industry is recovering and ready for an upswing, there is still a fair bit of uncertainly about the markets, regulations, currencies, growth and the future of the industry.
While we experienced plenty of headlines and changes in the hedge fund space in 2010, we can expect more of the same in 2011.
Over the last few years there were numerous predictions regarding investor redemptions, hedge funds and managed accounts. Despite predictions, what we are seeing is that managed accounts are stable players in the market place, but not to the extent anticipated. However, single account funds have become more prevalent.
In 2011, that trend should continue particularly with more assets coming from the sidelines. It is anticipated that a quarter of the hedge fund assets within the next few years will be in the form of managed accounts or single account funds.
As mentioned, there are billions in assets sitting on the sidelines waiting to enter the market at an opportune time. In anticipation, new funds are being considered or being formed. As has been the case historically, many managers will be using their own capital to launch funds; others have tapped into a flow of capital from investors who realise that hedge funds, as an industry, fare better than the broad markets irrespective of the economic times. Some of the new players may also be traders from banks’ proprietary desks who will need to find a new home as a result of the Dodd-Frank legislation. Though not breaking news, as Asian investors increase in the market, we may see a surge in fund of funds products as these funds provide such clientele with appropriately minimised risk and managed market exposure.
Investors demanding more from asset managers will also carry over into 2011. In 2010, we saw many investors enhance their due diligence programmes and maintain a watchful eye on fund managers prior to committing capital. In the earlier days of the hedge fund industry, the process of due diligence and capital commitment was completed within 2-3 months; today, we are seeing this review period extended to 6-9 months and in some cases as long as 12 months. We anticipate this trend to continue particularly as the market searches for a definitive direction and await increased economic growth and recovery.
UCITS continue to attract investors from all over the world, as the perceived safety and flexibility of these investments are being viewed as positive attributes. We have especially seen the fund of funds Asian investors moving toward UCITS as their top choice for investment products. Many US managers also see UCITS as a potential growth engine for their firms. However, unlike the 130/30 funds that turned out to be more of a “fad”, UCITS are very much a product that will continue to be in favour in 2011 and beyond.
Asia continues to be an inviting place to do business. Its open door policy will attract more managers and investment dollars, particularly in light of the fiscal and currency difficulties in Europe and the United States. In 2011, we will see more managers, funds and service providers starting to operate in Asia.
The trends we saw in Asia just five years ago are being observed today in South America, particularly Brazil. In the next few years, we will see a greater focus being placed on this new industrial and commodity rich powerhouse. When we talk about new and emerging markets, Brazil should be on an educated investor’s watchlist.
While we are anticipating growth in the hedge fund industry, many funds will be forced to close their doors in 2011. The last few years have been particularly difficult for smaller funds and those hard hit by redemptions from 2007-2010. Many of the managers in this situation have been keeping the doors open with infusions from their own operating capital; they have also taken reduced bonuses and employees have experienced flat compensation packages.
The result of several years of capital infusion and very little or no external capital, coupled with an anticipated increase in costs (particularly in regulatory and due diligence), will force some to wind down, scale down or look for alternatives such as outsourcing their noncore infrastructure components (technology, operations, finance, accounting and regulatory). It will take some ingenuity on behalf of these managers to keep the fund open and survive to see 2012.
For many years there has been talk of fee pressures with many saying the 2/20 model will not be sustainable and investors will eventually demand lower fees. Until recently, many investors have asked for a decrease in fees with few actually receiving them. Of course smaller managers or managers looking to expand with a few strategic investors, while balancing the need to increase assets, tend to acquiesce. Seed capital providers continue to do individual deals, but on the whole, we do not see a trend where fees in the industry will fundamentally change or that the model itself will change. For 2011, there will continue to be discussions and exceptions, but without an unforeseeable event 2/20 is the industry standard for the foreseeable future.
On the management fee side of the 2/20 model, the cost of being in the hedge fund business is exponentially increasing. The 2 per cent management fee structure may be insufficient particularly for smaller funds. One clear achievement of the new regulations and investor demands is to increase the barriers-to-entry and the cost of staying in the industry. Thus, smaller funds and emerging managers will need to look for infrastructure and management cost savings to ensure staying power. As such, in 2011 we will see more outsourced CFOs, COO, CCO and CTOs.
It is within a realm of possibility to see the establishment of operational hedge fund hotels offering services with distribution style platforms or a proliferation of ”hotels”, which have been around for years, that provide some light infrastructure.
One cannot talk about the industry and not discuss governance. Specifically, whether a professional directorship organisation with hundreds of clients and an infrastructure to support each director, or a single non-affiliated director that has several dozen clients is employed – the industry is seeking more governance. By way of comparison, a US Mutual Fund director’s role is very structured and very much imbedded in managing a fund.
Whether hedge fund directors will be asked to move in this direction is unclear. A couple of obstacles to this reality are fees, which are much higher for a US mutual fund director, and the higher risk of litigation for a hedge fund director. It is probable that the hedge fund industry will settle into a “happy medium” when evaluating the future of its directorships.
In the end though, it is important to point out that US hedge funds do not have a mandatory board or mandatory advisory body. The general partner or manager calls the shots. There is some talk about establishing of governance sponsoring organisations who will oversee the managers, but those plans are still very much on the drawing board.
Beyond a new fashioned board of directors, the role played by the manager, administrator, prime broker, auditor, third party marketer/consultant and investors will become increasingly important in delivering governance to the funds.
Unfortunately, 2011 will not see the final word on a new governance protocol, but the pressure by investors will continue to mount throughout the year, the result of which will be the beginning of a new governance regime.
We have also seen changes in prime brokerage over the last few years. In 2010, we saw some micro primes merge or close their doors. The majors began to re-offer services that were limited during the credit crisis. Though it is still difficult to obtain credit and the primes are very selective about the funds with whom they are willing to work, primes are getting back to business.
We anticipate that 2011 will see more consolidation, particularly in the micro prime arena, and the major primes will continue to enhance and expand their services to hedge funds.
Administrators will see consolidation. Smaller administrators will find it increasingly difficult to make technology investments and provide the array of services that hedge funds demand. Costs that have been relatively contained over the last few years will be increasing and, as the market opens up, retention of qualified professionals will become a challenge.
Smaller service providers have emerged over the past few years primarily due to market displacements. These are primarily individuals who out of necessity became temporary CFO’s and COO’s. In 2011 we will see a number of those professionals take on in-house employment with the new funds and organisations.
Though Advent remains the dominant player in the industry for portfolio accounting, other firms are making headway. Firms like Eagle, EZ Castle, Koger, Sungard and an array of others all have various applications and services that provide the functionality hedge funds need to survive.
The new trend, however, is cloud computing. Simply put, it is the ability to have an applications service provider (ASP) house all of the manager’s hardware and applications in a secure environment while providing the manager with the same capacities and access without the need to deal with the servers and the challenges of maintaining a data centre.
Business continuity is easier in this environment as well. This concept is not new and some of the larger firms have been working with these types of models for a few years. It is a model that certainly is not for everyone, but more funds will be exploring it and implementing it as their answer to their technology needs.
Managers continue to look for better operational models and there are numerous administrators that have jumped in to assist hedge funds with middle office functionality. Investors like funds of a certain size to carry its own operational infrastructure. Just like in technology, managers will try to do more with less, while keeping in mind that there are solutions on the market that assist with operations, yet do not break the bank.
Summary 2011 at a glance
We expect 2011 to be a year that will see growth, both in assets under management and in the number of funds on the market. We see some consolidation of service providers particularly when it comes to administrators and micro-primes, which is indicative in a maturing industry.
In addition, we will see operations, technology and compliance change fundamentally over the next 3 to 5 years with 2011 being the launching pad due to an increase in capital to implement infrastructure improvements that have been held over the last few years.