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Greater market discipline and more due diligence predicted for 2010

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This year will see greater market discipline from investors and an increased focus on due diligence by providers and custodians, according to speakers at a seminar hosted by offshore law firm Walkers.

Greater allocations to hedge funds were anticipated at the expense of equities, while the latest regulatory waves and the next likely bubbles in the market were also debated.

Joel Press, managing director of Morgan Stanley’s prime brokerage division, Todd Groome, non-executive chairman of the Alternative Investment Management Association, and Gregory Zuckerman, author and special writer with The Wall Street Journal, were among those offering their predictions.

"In today’s environment, there can no longer simply be a checklist to confirm a process. Potential investors must look at what motivates and drives the relevant provider," says Ingrid Pierce, partner with Walkers and head of the firm’s Cayman Islands hedge fund practice. "Custody diligence is very much at the forefront of people’s minds. Key questions include whether counterparties have the ability to move or re-hypothecate assets and whether contracts will hold up in an insolvency."

Investigative diligence, which looks in a very detailed way at precisely what various providers do, not just what they say they do, has also become a key focus as investors and other players ramp up their policies in this area, according to Pierce.

"It is important for both funds and investors to work out well in advance exactly what their exit strategy will be and how the provisions in the fund’s documents will actually work," she says. "The heightened levels of diligence we have seen throughout the investment process are not going to diminish anytime soon. All participants, including legal counsel have to increase our awareness of the issues and address key areas of risk with our clients."

Highlighting some positive trends in hedge funds, Aima’s Groome pointed to new allocations going to a variety of strategies. For example, managers in Asia are seeing 75 per cent of net new allocations coming from the US, primarily from pension funds. He also noted the launch of new hedge funds represents a clear increase in confidence.

"Market discipline from investors is back with a vengeance," said Groome. "Investors are asking for greater transparency. They want to use the transparency to create a more idiosyncratic contract for their particular situation and a particular strategy."

Morgan Stanley’s Press anticipates hundreds of smaller start ups in 2010 and said that seeding is more important than ever. With inflows still coming into the market, Press predicted that the industry will be worth USD3trn four years from now, compared to the current estimated value of USD1.8trn.

"There is no need for hedge fund fees to go down," Press said. "If you look at long-term investing, hedge funds are absolutely performing better than any other investment vehicle. Investors are looking to replace equities with hedge fund allocations and hedge funds are increasingly being used as an equity substitute."

The seminar also featured an in-depth examination of the role of fiduciaries, notably issues of responsibilities and accountability, from Guy Locke, partner and joint head of the corporate and financial restructuring group at Walkers, and Scott Lennon, senior vice president at Walkers Fund Services.

"It is a brand new world for hedge fund directors. Questionnaires are more extensive and elaborate and people want to know that manuals have been fully tested," Lennon said. "With changing standards of care and liability caps for auditors and other service providers, managers are in a tough negotiating environment. It is important to understand the whole picture of risk and where it will fall if things go wrong."

The Wall Street Journal’s Zuckerman said we are in an age of bubbles, citing housing, energy, Asian currencies and technology stocks as examples of bubbles the market has experienced over the past decade.

"The next bubble may be emerging markets, Brazil, China, or pockets of real estate in Asia or Australia," Zuckerman said. "Everyone is worried about the next investor. There is an incentive to increasingly pile on trades and now it is much easier to express trades using ETFs, synthetic CDS and other types of derivatives. Managers today are fully invested and talking about adding leverage, but they don’t really believe in the long term nature of these investments. It might work out in the short term but long term you wonder if they can all get out."

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