By Simon Gray – The hedge fund sector in the United States, its cradle and still by a long way its biggest and most important centre, has emerged successfully from the crisis that beset the global financial industry between 2007 and 2009. As Global Fund Media publisher Sunil Gopalan commented at the Hedgeweek USA Awards 2011 in New York on June 16: “These awards celebrate the way in which hedge fund investment advisers and service providers have led the US industry out of the crisis through their expertise, innovation and adaptability.”
Nevertheless, the environment in which fund managers (or investment advisers), investors and service providers operate has changed permanently, especially with regard to regulation of hedge fund firms. That was underlined on June 22 when the Securities and Exchange Commission unveiled its long-awaited rules to implement the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as they apply to hedge fund and other private fund advisers, many of which will now become subject to registration with and regulation by the SEC, or state regulators in the case of smaller firms.
Among other things, the announcement confirmed earlier SEC guidance that the compliance deadline for firms obliged to register for the first time under the 1940 Investment Advisers Act as well as ‘exempt reporting advisers’ would be pushed back from July 21 this year to March 30, 2012, a decision that reflects long delays in drafting and agreeing the detailed rules and the resulting conundrum facing firms that were uncertain whether or not they would be caught up in the regulatory net.
The extension of regulatory and reporting obligations most notably involves the closing of a loophole in the 1940 legislation that enabled advisers to qualify for an exemption for firms with fewer than 15 clients by arguing that their clients were funds rather than their underlying investors. But many large hedge fund firms are already registered with the SEC anyway following an earlier, abortive attempt by the regulator to change the rules in the mid-2000s.
The changing regulatory landscape is not the only way in which the environment for hedge fund and other alternative investment firms has changed as a result of the crisis. Arguably just as important – although largely pushing in the same direction – is an increase in client expectations in areas such as transparency and often liquidity, accompanied by more intense initial due diligence and ongoing scrutiny that frequently extends to key service providers and technological capabilities.
These developments, along with a gradual shift in the relative weight of firms’ assets under management from high net worth individuals to institutional investors that was already evident before the onset of the crisis, have pushed hedge fund firms toward greater ‘institutionalisation’, pushing up costs and seemingly giving an advantage toward the biggest firms, usually measured as those with more than USD5bn in assets under management.
These large managers are also those probably best placed to accommodate demands for investment through managed accounts and other single-investor structures, which over the past three years has become much more popular among pension schemes, family offices and other large allocators to hedge funds. That said, the growth of managed account platforms and other alternatives to commingled fund vehicles, as well as advances in administration IT systems and software, have helped to ease the cost implications for both managers and investors, leaving the barriers to managed account investment rather lower than they were three or four years ago.
There are other reasons, however, to question whether the future inevitably belongs to the biggest hedge fund firms. Paradoxically, some industry analysts suggest that the very process of institutionalisation is throwing into sharper relief the performance advantage frequently attributed to smaller, more nimble managers over those running many billions of assets – especially as a rebound in capital flows into the industry raises anew the issue of overcrowding that reduces the gains to be made from previously highly profitable trades or investment niches.
The past few weeks have seen the spotlight turned on Paulson & Co, once an unfashionable smaller player that was transformed by its hugely successful bets against the sub-prime mortgage market. Today, critics point to Paulson’s loss of at least USD107m on controversial Chinese timber company Sino-Forest as evidence that now that his firm manages more than USD37bn, founder John Paulson is struggling to repeat the extremely profitable trades that made his name. Not least, such large volumes of capital make it harder to make investments without moving their price and to sell positions quickly if they turn sour.
The volatile fortunes of Paulson & Co – which, it should be noted, recovered from a significant drawdown in the first half of 2010 to deliver another stellar performance for the year – are one reflection of the turbulent conditions experienced by the hedge fund sector as a whole over the four years since the crisis began to take shape in the first half of 2007.
As Ron S. Geffner, a partner and head of financial services at law firm Sadis & Goldberg, noted in his keynote address at the Hedgeweek USA Awards, over the intervening period hedge fund assets plummeted by almost a third as a resulting of negative performance averaging around 20 per cent across the industry in 2008, coupled with withdrawals of capital by investors spooked by the falling value of their investments or simply in need of liquidity themselves.
The wave of redemptions compounded hedge fund firms’ existing difficulties by forcing the sale of investments at a time when the liquidity of many assets classes had receded, resulting in widespread resort to investment restrictions such as gates, side-pockets and suspensions. These in turn prompted other investors to seek to withdraw capital lest they find their fund allocations saddled with the most illiquid and unattractive assets remaining in the portfolio.
At the time some analysts viewed these developments as an Armageddon scenario that would lead to the collapse of much if not most of the sector – especially after the uncovering in December 2008 of Bernard Madoff’s supposed USD65bn investment management business as a gigantic Ponzi scheme.
But as Geffner observes, that proved a nadir from which hedge fund firms have climbed back over the past two years by providing renewed evidence of their ability to deliver consistent, uncorrelated returns, and especially to protect capital during periods when the performance of mainstream asset classes has been mediocre at best. For instance, Hedge Fund Research’s HFRI Fund Weighted Composite Index fell by 1.28 per cent in May, but this compared with declines of 1.35 per cent for the S&P 500 index, 1.88 per cent for the Dow Jones Industrial Average and 1.33 per cent for the Nasdaq Composite.
Renewal of faith in traditional hedge fund virtues has brought investors back to the sector as quickly as they left, with HFR reporting that aggregate hedge fund assets set a new record of more than USD2trn at the end of the first quarter (other surveys put the total assets under management figure lower, and in some cases substantially higher, but all other them confirm the overall trend).
While firms that were not affected by problems with illiquid assets often found themselves in the unfortunate position of being treated as ATMs by investors at the height of the crisis, in many cases the fact that they treated clients correctly and did not resort to redemption restrictions has served them well as capital started to flow the other way. A number of managers confirm that many of the same investors who redeemed all or part of their investments in 2008 or 2009 have subsequently come back with fresh allocations.
According to TrimTabs Investment Research and industry data firm BarclayHedge, hedge funds attracted USD17.5bn in April, the fourth straight month of net inflows. HFR reports that 298 hedge funds were launched in the first three months of 2011, the largest quarterly figure since 2007, and while attrition is also high – a total of 684 funds were liquidated over the 12 months to the end of March – the net increase of 195 in the total number of funds over that period is also the highest since 2007.
These numbers bear out a survey carried out earlier this year by professional services firm Rothstein Kass, which currently serves more than 2,000 offshore and US single-manager hedge funds and funds of hedge funds. The firm’s resulting report on industry trends, entitled 2011 Hedge Fund Outlook: Brighter Days Ahead?, says that more than 75 per cent of the hedge fund managers polled believed that this year would see more fund launches than 2010, while more than 60 per cent expected fewer fund closures.
The survey, conducted among 313 managers of which 70 per cent managed less than USD500m in assets, found that although around one-third of respondents believed 2011 would be a difficult year for the hedge fund sector, the proportion was down from nearly 70 per cent who expected a tough 2010. More than 60 per cent of the managers polled expected hedge fund firms to be able to attract staff from other parts of the financial industry as they grew, while a similar proportion expected new launches to be more dependent upon seed capital than in 2010.
More than three-quarters of survey respondents expected to enjoy an increase in assets under management in 2011, and nearly 60 percent indicated that anticipated that assets would grow by 25 per cent or more. By contrast, although last year 67 per cent of managers anticipated raising significant new capital, only 32 per cent foresaw an increase in assets as large as 25 per cent.
“Over the past two years, the sector has again shown its resilience by adapting to meet the evolving needs of its investors,” says Howard Altman, co-chief executive and principal-in-charge of the financial services group at Rothstein Kass. “More than 70 percent of hedge fund managers anticipate that institutional investors will be the dominant source of new capital in 2011, in stark contrast to our 2007 survey results [when] only 20 percent of respondents reported that institutional money would come to dominate the industry.”
The report confirms the movement toward institutionalisation, with more than 85 percent of respondents expecting institutional investors to be more averse to high concentrations of illiquid assets, three-quarters expecting general partner investment to be a greater consideration for investors evaluating hedge fund allocations, more than 80 per cent expecting institutions to continue to prefer allocations to larger hedge funds, and nearly 65 per cent expecting hedge fund firms to offer special terms to pension funds and sovereign wealth funds more frequently.
Altman argues that this trend is now being reflected in the make-up of industry inflows. “Those firms that took the lead in developing and implementing institutional-quality operational practices, from succession planning to reporting, are now benefiting from increasing allocations from pension and defined benefits plans seeking to overcome their own funding shortfalls deepened by the crisis,” he says.
“The institutionalisation of the hedge fund industry is likely to accelerate in coming years. Though regulatory initiatives have played a role, the push for greater communication and transparency is still predominantly a market-driven phenomenon. The fiduciary responsibilities of institutional advisors continue to inspire enhancements to due diligence processes, as investors now more commonly look beyond performance at a range of considerations, including succession planning and operational and reporting practices.”
“Enhancements in these areas have helped to restore investor confidence, and the regulatory focus is likely to persist. When we commissioned our first industry survey in 2007, less than 10 per cent of respondents expected significantly more industry regulation. As an ever-increasing portion of ‘Main Street’ has gained access to alternative products through their pension plans, regulatory scrutiny has logically intensified.”
But the world has changed since 2007, when the SEC was still smarting from the collapse of its previous attempt to regulate the hedge fund sector. In December 2004 the regulator had introduced a new rule that would require investment advisers to count individual investors rather than funds in calculating their number of clients for the purposes of determining whether or not they were required to register under the Investment Advisers Act.
However, in June 2006, just four months after the deadline for registration, the US Court of Appeals for the District of Columbia struck down the rule in a case brought by Bulldog Investors co-founder Phillip Goldstein. The court decided that the regulator had acted arbitrarily in requiring advisers to ‘look through’ hedge funds to count the investors for the purposes of determining their number of clients, which it said strayed too far from the plain language of the Advisers Act and was beyond what Congress intended when it passed the legislation.
Today the Dodd-Frank Act has remedied the deficiency of the SEC’s powers, even though the rulemaking process has proved more cumbersome and lengthy that expected. Speaking at the open meeting that adopted the new measures, chairman Mary Shapiro said: “Today’s rules will fill a key gap in the regulatory landscape. In particular, our proposal will give the Commission, and the public, insight into hedge fund and other private fund managers who previously conducted their work under the radar and outside the vision of regulators.”
The rules, Shapiro says, are designed to provide the SEC and the public with information about the business operations of investment advisers, their conflicts of interest, disciplinary history and investment strategies. Advisers must reveal the size and strategy of their funds and the identity of critical service providers such as auditors and prime brokers, although the SEC says they will not require any disclosure that could harm the interests of fund investors. The rules also implement provisions in the Dodd-Frank Act giving regulatory responsibility for certain smaller investment advisers, with between USD25m and USD100m under management, to state securities authorities.
The rules also clarify the foreign private adviser exemption for firms without a place of business in the US and the exemption for advisers to private funds with less than USD150m in assets under management in the US. On the agenda for the future is the SEC’s plans to adopt Form PF, through which private fund advisers would provide additional information on a non-public basis to give the regulator and the Financial Stability Oversight Council insight into the systemic risk profile of advisers and the private funds they manage.
Shapiro insists it was important for the rules implementing the private fund and related investment adviser provisions of the Dodd-Frank Act to be adopted before the legislation becomes effective on the first anniversary of enactment, July 21, to provide certainty and clarity about the registration requirements and related exemptions. However, the deadline for compliance has been put back nearly nine months to facilitate an orderly transition and enable fund advisers to achieve compliance, as well as to give the SEC time to adjust its registration system to accommodate private fund advisers as well as the change in threshold for registering with the SEC versus the states.
The shift toward more extensive regulation is far from confined only to the US. Many of the country’s hedge fund firms are watching carefully developments in Europe, where the European Union has passed legislation, the Alternative Investment Fund Managers Directive that will eventually require compliance on the part of all managers seeking to access sophisticated investors within the EU, whether or not they or their funds are domiciled within the union.
However, for at least another seven years, until mid-2018 at the earliest, foreign managers of alternative funds will still be able to access EU investors through national private placement regimes. The fact that the legislation did not shut foreign managers and funds out of the European market altogether, as was mooted at one point, owes much to intense lobbying by the US hedge fund industry as well as members of the administration in Washington.
In the meantime a number of US hedge fund managers have joined the trend in Europe toward creating vehicles compliant with the highly regulated Ucits (Undertakings for Collective Investment in Transferable Securities) regime. Although Ucits funds were conceived for cross-border retail investment within the EU, the big attraction for alternative managers is that many European institutions have much greater leeway to allocate to such funds than to offshore vehicles with little or no regulation; against that is the higher cost and transparency, as well as liquidity requirements and investment restrictions that do not suit all strategies.
Even offshore jurisdictions traditionally known for regulating investment funds and managers with the lightest of touches, if that, are falling into line with the global insistence that hedge funds should be subject to greater supervision. The government of the Cayman Islands, the world’s largest offshore fund domicile, has just announced plans to require master funds that are part of a master-feeder structure to register with the territory’s financial regulator, the Cayman Islands Monetary Authority.
To be sure, this does not indicate a wholesale revolution in the regulation of Cayman funds. The registration obligation is expected to apply only to Cayman-incorporated master funds that belong to a structure that includes at least one CIMA-registered feeder fund; it should not entail onerous additional reporting requirements; and it will not cover closed-ended private equity funds. The registration fee is expected to be a modest one, around USD1,500 per entity, and the industry will get plenty of advance notice for the registration of existing funds.
However, Cayman-headquartered law firm Maples and Calder says the change aims to demonstrate that Cayman is sensitive to the concerns of the global community about oversight of hitherto more opaque areas of the financial industry. “As generally all the assets of the fund structure are held at the master fund level, the authorities in the Cayman Islands considered it prudent to bring the master funds within their regulatory oversight,” the firm says.
“While a number of reviews conducted post the financial crisis by various international bodies and regulatory authorities have been very positive on the Cayman Islands as a jurisdiction, it had been remarked that an area of potential improvement was to increase the regulatory status of these master funds. This proposal is therefore aimed at plugging that small gap in the regulatory landscape of the jurisdiction.” In the new environment for the hedge fund industry, from George Town to Connecticut, increased scrutiny is now a fact of life.