There was a time when hedge fund managers relied solely on their investment performance to attract investors. Management and performance fees, redemption or governance issues were hardly a topic, and the operational aspects of running a fund were not discussed at all.
Since the financial crisis, investors’ attitudes have changed, and their demands have resulted in increasing operating costs, greater difficulty in raising funds and higher barriers of entry for new funds.
Offshore law firm Walkers noted in its annual analysis of fund trends involving funds it helped set up during 2014 that going into 2015 the hedge fund market is “characterized by renewed confidence and vigor as managers make a return to fundraising.”
Following a dearth of fundraising in the wake of the financial crisis, now even mid-sized managers and start-up funds are gaining better access to new capital. Managers attempt to broaden their investor base by both reaching into new markets, such as U.S. managers extending their fundraising efforts to Europe and Asia, and by offering new products.
New products, such as single investor funds and managed accounts, have often come in response to investor calls for greater transparency and more liquidity in their hedge fund investments in the wake of the many liquidity and redemption issues spurred by the 2008 financial crisis.
Consultants Ernst & Young believe that to win assets in the future, managers will have to cater much more to investors’ needs and specific client types. “They must be willing to adjust fee levels or expense ratios, provide separately managed accounts, and supply registered liquid alternative products,” the firm concluded in its 2014 Global Hedge Fund and Investor survey.
So far the managers who were the most flexible in adapting to the needs of investors have been most successful in attracting new capital.
Launching new products not only allows managers to attract more assets from existing investors, it also opens up access to investor groups that had not considered investing in hedge funds, EY found.
Managed accounts, for example, increase operational complexity, but they can overcome fee objections and are more flexible to be tailored to investor requirements.
Liquid alternative funds cater to the demand for registered liquid alternatives, particularly in Europe, and help attract private wealth platforms that traditionally offered mutual funds to their clientele, EY said, adding that long-only funds also offer great opportunities but face stiff competition from traditional asset managers.
Smaller managers, in contrast, often cannot afford the infrastructure expense required to launch new products and attempt to leverage investment strategies and products already on offer. And the funds that do launch new products incorrectly assess the costs and complexity involved.
Michael Serota, co-leader, Global Hedge Fund Services at EY, said, “Our survey shows that managers who have not yet launched new products often underestimate the investment required to successfully bring a product to market and do not perform sufficient planning – this is particularly true for registered funds due to the increased operational complexity in reporting and compliance functions.”
The added cost of new products is often so significant that margins are squeezed. Fiona Carpenter, EMEIA Leader, Global Hedge Fund Services at EY, said this is only logical.
“Separately managed accounts often come with fee concessions that impact margins and add complexity to reporting, sub-advisory relationships can carry unique reporting requirements and service provider demands, and registered liquid alternatives are lower fee products that require significant investment to set up. In fact, the negative impact on margins is most acute in Europe and among larger managers, both of whom have been at the forefront of product development in registered liquid alternatives. Without scalable operations, managers are likely to take a hit on margins when they launch new products.”
Walkers’ analysis also confirms a reduction in fee levels. The usual 2 percent management fee and 20 percent performance fee arrangement is not as common for start-up funds.
Three-quarters of newly registered funds have management fee of less than 2 percent. However, only 19 percent of new funds make concessions with a less than 20 percent performance fee.
The law firm also observed that for most new hedge funds structures “liquidity is still king.”
“We continue to see a greater focus on corporate governance and an aversion to liquidity measures such as gates,” said Ingrid Pierce, global managing partner, Walkers. “Investors don’t want very long lock-ups or complexities. They want simple, clear and comprehensive disclosure.”
While some managers are able to establish structures with longer lock-ups and side pockets for special investments, investors are reluctant to invest in funds with overly complex gates and side pockets. And larger investors are routinely rejecting any form of redemption in kind, the law firm said.
The firm’s survey shows that 40 percent of new funds operate with quarterly liquidity, and 39 percent offer redemptions within a month.
The share of funds with less than 30-day periods for redemptions jumped from 25 percent to 32 percent, constituting a notable downward trend. Meanwhile, the use of lock-ups is declining, as investors resist any mechanisms that lower liquidity.
The strong focus on corporate governance among newly formed funds is reflected in the use of independent directors and other fiduciary advisers. Walkers noted that “the introduction of the Cayman Directors Registration and Licensing Law – which requires directors of entities covered by the law to either register or apply to be licensed by the Cayman Islands Monetary Authority – has given the regulator greater opportunity for more regular contact with operators of funds, thus increasing oversight and satisfying the calls of certain institutional investors.”
Transparency remains key for investors, a need that managers attempt to meet by reporting to all investors.
Typically a fund’s corporate governance framework will feature some form of independence, with 81 percent of new funds in 2013 and 2014 using professional directors who are independent from the manager. Most boards (67 percent) are split, but in their majority independent (80 percent). The share of purely independent boards, meanwhile, declined from 29 percent to 14 percent, Walkers said.
A DMS panel reviewing industry trends in December noted a “regulatory fatigue” among industry practitioners, with FATCA in the U.S., the Alternative Investment Fund Managers Directive in Europe or the Statement of Guidance in Cayman all bringing regulatory updates for funds at the same time.
“In particular for small hedge funds, it has been a struggle to deal with this,” said Derek Delaney managing director with DMS in Ireland. Most managers are looking forward to 2015, when there is not going to be the same level of new regulations, he added.
For Kathleen Celoria, executive director, DMS North America, Cayman continues to lead the industry as a jurisdiction of choice. But of the three main themes for 2014 – cost, capital and compliance – cost is an important issue for managers given the general pressure on margins, and something that Cayman needs to be mindful of.
Delaney added that in the 1990s Bermuda used to be the preeminent center for hedge funds, but then added extra layers of regulation and costs at a time when Cayman came out with similar legislation but no significant regulatory and cost burden. Now Cayman may find itself in a comparable situation adding more regulation, when Bermuda and other jurisdictions are attempting to make their regulation simpler, cheaper and more transparent.
“People do what’s best for their clients from a cost and efficiency perspective,” he warned.