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Are hedge funds living up to investors’ expectations?

Robert Mirsky, Global Head of Hedge Funds and a Partner at KPMG’s UK Financial Services Practice and Jon Mills, UK Head of Financial Services Audit and Global Head of Audit for KPMG’s Investment Management and Funds Practice – share their views with Hedgeweek on some of the macro trends evolving in the hedge fund industry.

There’s no denying that hedge funds remain in the upper echelons of the investment universe. Performance expectations remain high yet at the same time, as the industry becomes increasingly saturated with institutional assets, investors are giving managers more time to achieve their targets. Whereas previously, before the financial crisis, fund-of-hedge-funds and private wealth clients bolted out of the stable at the first sign of performance lag, today’s investor is a little more forgiving.

Looking at this year’s performance figures, they don’t make for too bad a review. The average global hedge fund is up 5.50 per cent through September according to the HFRI Fund Weighted Composite Index, and is up 7.05 per cent over the last 12 months. That’s an average figure. Those investors who have managed to allocate to managers returning double-digit returns year-to-date, particularly those focused on sector-specific strategies such as healthcare and technology or distressed debts will be more than satisfied. Indeed, 41 per cent of Asia Pacific investors plan on increasing their allocations to hedge funds over the next 12 months according to a recent Preqin survey.

But despite the importance performance plays, and always will play, it isn’t necessarily at the top of investors’ list of concerns when choosing which managers to invest in. Against a new regulatory backdrop, with the AIFM Directive and Dodd-Frank Act kicking in to gear, and Solvency II and FATCA on the horizon, investors are increasingly likely to focus on other factors such as transparency and regulatory compliance.

“I think performance is absolutely still key, it just isn’t as high up the list,” says Robert Mirsky, Global Head of Hedge Funds and a Partner at KPMG’s UK Financial Services Practice.   
 
“Investors are much more institutional now and this is forcing much of the change in the industry. In our latest global survey entitled The Cost of Compliance* most managers, when asked about regulation, said that they were already doing a lot of what is now being required under the likes of AIFMD. If not, they were seen as being un-investable.”

Managers are responding and listening to investors’ needs it would seem. They know all too well the importance of having an institutional-quality governance and risk management framework. For a lot of institutions like UK pension funds, choosing to invest directly into hedge funds means mitigating risk. They are naturally drawn to the biggest, blue chip names. 

As Mirsky observes: “One manager I spoke to was down to 15 per cent fund-of-funds in terms of total investor assets and welcomed the opportunity to attract longer-term institutional investors. Most large hedge fund managers share this mindset. Their goal is to be matched with like-for-like institutional investors. That’s a big change that we’ve noticed over the last couple of years.” 

This demonstration of operational excellence may be creeping up to the top of the list but performance will also be there or thereabouts. Having a first-class infrastructure and a poorly performing strategy is no guarantee investors will stick with a manager, they’ll just afford them more time.

Jon Mills, UK Head of Financial Services Audit and Global Head of Audit for KPMG’s Investment Management and Funds Practice, comments: “I had a meeting recently with what was previously a multi-billion dollar hedge fund. Today it no longer is because of poor performance over the last 18 months. They have a robust governance and operational framework, they are very transparent with investors, but they just haven’t been able to deliver on performance.”

In Deutsche Bank’s Hedge Fund Consulting Group’s second annual operational due diligence survey this year, which polled investors globally representing over USD2.13trillion in assets, almost 75 per cent ranked a fund’s compliance and regulatory framework as the top priority for 2013. It noted that in a clear sign of the growing importance of operational due diligence teams, 63 per cent of investors would not reconsider investing in a fund previously vetoed by an ODD team. 

This is the new reality that hedge fund managers live in. The nuts and bolts of a fund’s operations are under just as much scrutiny as its performance track record. 

Mills says that things like Solvency II are naturally pushing investors to focus even more on operational due diligence. This has led to KPMG over the last two years putting together its own ODD teams in place both in the UK and, more broadly, in the US and Asia. “We are getting increasing demands from institutional investors to go in and perform operational due diligence visits across the wider alternative funds market. 

“I’m pretty sure a lot of this is being driven by the weight of regulatory change and the ever increasing focus on risk governance controls. I’m not sure it will change how people invest but it will certainly add to the level of operational due diligence being conducted on managers.”

The danger of pervasive regulation is that the hedge fund industry’s independent streak – it’s spirit of innovation – will be stripped away. That it will morph into a more anodyne version of itself. 

“The two-man Mayfair operation is going to become an increasingly tough model to follow with the way that regulation is evolving. Anecdotally, I heard from one hedge fund client that they had lost a couple of their star members and a lot of that was down to the growing level of institutionalization and a feeling that they were being to forced to work in a more restrictive environment. 

“Unfortunately, if managers want to attract money from big institutions, it’s hard to see any other way of doing it. Regulation has certainly raised the barriers to entry.”

But this is not some rude awakening. Hedge funders have had plenty of time to adapt and prepare for today’s Brave New World and as Mirsky points out previously, managers have long understood that “real institutionalization is not coming as a result of regulation. It’s coming as a natural evolution of the industry. 

“That’s the way it should be. Regulation is raising the standard but apart from providing certain reporting requirements, for the most part the managers we speak with are saying that they’re not sure to what extent regulation is adding value to investors. 

“From an operational cost perspective, they are far greater for smaller managers on a relative basis than multi-billion dollar managers. In our latest report, we show that it costs USD700K on average for small managers, USD6million for mid-sized managers and USD14million for large managers every year on regulatory compliance. That USD700K cost for a manager running USD20million is impossible. It’s unsustainable.”

Meaning there will inevitably be further consolidation within the industry going forward. 

“Larger managers are looking at this cost issue as a potential opportunity to bring smaller managers on board and build them into their platform,” adds Mirsky. 

One natural consequence of improved transparency between managers and their investors is a better alignment of interests when it comes to fee structures. Whether it be 2/20, 1.5/15 or even 0/30, investors are keen to establish the right fee level with the right manager for the right relationship to flourish.

The point here is that a multi-billion dollar manager is far more likely to agree on a lower management fee than an emerging manager who is still in the middle of capital raising and build out their AuM.

“A large manager with USD30billion in AuM does not necessarily need that management fee to keep the lights on, retain key operational staff and make sure there’s a minimum level of infrastructure in the business. I think that’s where you’re starting to see this greater alignment of interests between the manager and investor. For very small managers, you don’t tend to see potential investors saying ‘ I want a massive discount on management fees’ because they understand that by doing so it becomes increasingly difficult for such managers to concentrate on the investment process. 

“They just end up shooting themselves in the foot,” says Mirsky.

Mills agrees, adding: “Investors and managers who get that right are better positioned for a longer and potentially more successful relationship than those who don’t. It takes some of the stress out of the relationship.”

One option being explored, more so by established managers, is the diversification of their investor base by offering different fund structures to different investors. Alternative UCITS funds, regulated hedge funds like QIFs and SIFs, and 40 Act mutual funds in the US are beginning to gain favour with managers.

“Over a three-year term, managers of several billion dollars said that they intend to grow into that regulated space according to our latest report,” confirms Mills. “But what is important to remember is that it is often not possible to trade the exact same strategy as used in offshore funds. Also, managers of regulated funds like 40 Act funds don’t get paid performance fees. 

“These products can help reach a different audience and open up a different distribution channel but they need to be aware of the trade-offs involved.” 

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