By Simon Gray - No-one is ready to say that the good times have returned for London’s hedge fund industry, but professionals say the sector is definitely on the mend after the traumas of the past three years, when a near-across the board slump in performance and a resulting wave of investor redemptions sent the industry worldwide assets plunging by at least 30 per cent (possibly more) from peak to trough. Today the trend remains resolutely in the other direction.
Although up to date statistics are lacking and in some respects verge on the anecdotal, and the recent trend toward firms setting up operations in multiple jurisdictions makes calculation even harder, there is little reason to believe that there has been any substantial shift since 2009, when London accounted for around two-thirds of European hedge fund management firms and an estimated 75 to 90 per cent of their total assets under management, according to promotional body TheCityUK and its predecessor, International Financial Services London.
The optimism is qualified, though. What is taken as a clear sign of the industry’s returning health, the number of new funds being launched and of start-up managers entering the market, has to be weighed against the evident difficulties managers, especially newcomers with little or no independent track record, are encountering in trying to raise capital, although firms with an established infrastructure that got through the downturn without infuriating their client base with redemption restriction seem to be faring better.
This is at a time when the increased transparency being demanded by investors, especially institutions, is adding to costs in areas such as compliance, risk management and reporting, and when regulatory changes are promising more of the same. And maddeningly, the downturn seems to have done little to tame the often-daunting costs inherent in using London as a base from which to do business.
“We found that rental prices were still very high when we moved office a year ago,” says Simon Dinning, London managing partner of offshore legal specialist Ogier. “Things seem to have recovered and indeed gone full circle in recruitment. The reality is that in the legal field it is an employee’s market now. Unfortunately some firms did have to let a number of people go, but things are picking up and firms are hiring again.”
He recognises that these trends reflect the rebound in business confidence in recent months. “We had a very busy end to last year, not just in funds but notably in equity capital markets transactions. This activity appears to be continuing in 2011. While I don't believe anyone is predicting an exceptional year, there is certainly a degree of confidence returning.”
According to Dinning, fund launches are taking place with, on average, smaller amounts of capital being raised than would have been the case three or four years ago, but even then there are exceptions. “There are still some decent-sized launches taking place involving established managers with a track record and perhaps access to a larger pool of capital,” he says. “But it may take all of this year and perhaps some of next year before some of the new start-ups really begin to raise significant pools of capital.”
Recovery from the market turbulence of 2008-09 may not yet be in full throttle but an improvement in the business environment is clear, according to Julian Korek, founding member of consultants Kinetic Partners. “What is noticeable is that funds that enjoy investor confidence have fared particularly well,” he says. “For example, there are new flows into funds that investors feel have good governance plus performance. In addition, there is a pattern of the larger funds getting bigger, which reinforces the view that larger managers with better infrastructure and governance are seen as better places to invest.”
He also notes the tougher environment for start-ups. “The influx of new managers into the market is picking up, but capital-raising for new funds is proving difficult unless the manager has come out of an environment where they are taking a fund with them,” Korek says. “For managers starting from scratch it is still an uphill struggle, but we expect an upturn in the establishment of new funds in 2011. Of particular importance is the significant number of prop teams leaving large banks and setting up on their own, often with bank support.”
Getting the right infrastructure in place is essential if these managers are to inspire confidence among investing institutions, according to Chris Cattermole, sales manager for Advent Software’s Geneva system for Europe, the Middle East and Africa. “A lot of managers spinning out of investment banks are used to having all the tools at their fingertips,” he says. “All of a sudden they need to think about building a business rather than just trading.”
The founders of start-up firms need more than just the technology, though. “They need to have someone who understands the industry as their de facto chief operating officer,” Cattermole says. “They have to keep abreast of all regulatory requirements, the requirements of the new EU alternative fund managers directive or the Ucits requirements if that’s relevant. In small firms there is often one person wearing multiple hats as the chief operating officer, chief financial officer and compliance officer. The need for such a person is often overlooked until the business starts to gain traction.”
Martin Cornish, an investment management partner at law firm K&L Gates, says the industry is probably benefiting from a lifting of some of the uncertainty that has surrounded it over the past couple of years, not only because of ongoing volatility in the markets, fears over the solvency of certain European issuers of sovereign debt and the risk of a ‘double-dip’ economic recession, but also the long-running soap opera of the European Union’s Alternative Investment Fund Managers Directive.
“It was beginning to clear by the third quarter of last year, but up to then there was so much uncertainty about regulation, tax and jobs that you’d have been a brave man to set up during that period,” he says. “Some probably did it out of necessity, but it wasn’t the ideal time, and money-raising was – and continues to be – a real issue.
“Some investors that lost a lot of money have adopted very conservative strategies going forward and won’t part with their money unless they’re pretty sure they know what they’re investing in and are confident that the manager has all the right capabilities. It’s taking a lot longer for people to get their chequebooks out, even where they may be keen to invest and ultimately will do so. Investors are conducting more due diligence, they are thinking about it harder, and they want to understand things that previously they did not feel they needed to understand. All these factors have affected money-raising for new funds.”
Meanwhile, managers face another headache in the increasing readiness of governments and regulators to set out stipulations on how individuals in the sector should be remunerated. Many UK-based investment firms have been caught up by the Financial Services Authority’s new Remuneration Code, which came into effect at the beginning of this year and is designed to prevent individuals within financial institutions having a monetary incentive to engage in behaviour that increases risks for their employer or the financial system.
There is certainly relief that the code’s provisions are based on proportionality rather than a one-size-fits-all approach, and most investment managers will find themselves in the fourth tier of firms that generate income from agency activity without putting their balance sheets at risk. The FSA says that in general, it does not expect tier four firms to find compliance with the code particularly onerous.
“The FSA remuneration code which has just been finalised has turned out to be a lot less invasive than was expected,” says Andrew Rubio, chief executive of outsourcing provider Throgmorton. “The FSA was smart enough to come up with this tiered approach, which means the bulk of asset managers are in the least onerous bracket. Obviously there are still issues to deal with, but they’re nowhere near what was expected at one point.”
Stuart Martin, an investment fund partner in the international financial services group of law firm Dechert, adds: “The general consensus is that it’s not as bad as originally thought, and as long as asset managers are within tier four, that should be OK.” But he notes that the EU’s AIFM Directive also contains provisions on remuneration, currently representing little more than broad principles that will have to be fleshed out over the next two years.
“The real sting in the tail is the extent to which the remuneration provisions of the AIFM Directive are harsher than those of the FSA,” Martin says. “I think there will be a lot of tax planning around the remuneration provisions in any event. With the directive, the devil may be in the detail of the level II measures.”
One issue that continues to intrigue some members of the hedge fund industry in London is whether the government is capable of getting its legislation and tax code in line to attract managers to domicile their products in the UK – and if so, whether that would be enough to attract business that currently goes offshore to Caribbean jurisdictions or the Channel Islands, or onshore to Luxembourg and Dublin (and to a certain extent Malta).
Kinetic co-founder David Butler does not see this as particularly likely, especially when the UK has failed to attract a great deal of retail Ucits fund business despite years of efforts to do so. “The other centres make much more effort in this area, marketing themselves as a more pleasant and relaxed environment in which to base a fund with the attendant tax advantages,” he says. “While the FSA has been keen to promote the UK as a [domicile] for funds, tax issues and higher costs have got in the way.”
Cornish concurs, saying: “Tax is the big thing. We already have rules that enable a manager to form a hedge fund without any investment restrictions from a regulatory point of view, but it’s the tax that is dragging behind, as is often the case. Without that clarity I don’t see people really using those rules. HM Revenue & Customs has not got off the fence and given us a clear picture of what the taxation of those funds would be. Until we have that, I can’t see it taking off.”
But Martin believes that in the new global regulatory environment, and given the upheavals in prospect once the AIFM Directive takes effect, UK-based fund structures may come to play a more prominent role. While most managers that prefer onshore vehicles are looking to Ireland’s Qualifying Investor Fund or Luxembourg’s Specialised Investment Fund, he believes the UK’s Qualified Investor Scheme also has potential.
“If you want a fund that is not subject to the constraints of the Ucits directives on an absolute return fund and might be happy to use derivatives to achieve synthetic shorting, a QIS might be very attractive,” he says. “One reason is that if a UK tax resident invests in an offshore fund, the fund generally has to seek reporting fund status in order for the investor to enjoy capital gains tax treatment when he realises his securities. The quid pro quo is that he would be taxed on the net income of the fund on an annual basis.
“The problem is that if you have a fund that is actively trading with a high turnover of securities or derivatives, a large part of its profit will probably be reportable. In those circumstances, a QIS has the benefit of white-listing, which means that trading activities are likely to be treated as capital activities provided it can demonstrate that it meets the diversity of ownership tests. A QIS might be attractive for people targeting UK tax-resident investors with a very specialised product.”
Martin’s colleague, Dechert tax partner David Gubbay, adds: “There are other reasons why UK management groups might want to have funds onshore. One is that the manager of an offshore fund has an additional compliance burden to ensure it doesn’t bring the fund into the UK tax net. You must have an offshore board that is credible, meets offshore and complies with various other rules, which can sometimes be a hassle and cost the fund additional fees.”
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