Bloomberg Hedge Fund Start-Up Conference 2013: Key Points
Hedge fund managers of the pre-crisis mould typically needed little more than a Bloomberg terminal and a rudimentary office to attract the attention of investors. Allocations were made based on trust, and it was not uncommon to see managers launching with less $5 million running $1 billion after a year. Words and concepts such as rehypothecation, business continuity planning, counterparty risk, operational due diligence and corporate governance did not figure highly in the hedge fund industry’s lexicon. The hedge fund industry has undergone an enormous transformation for both better and worse. Regulation on both sides of the Atlantic has ramped up costs exponentially while the institutionalisation of investors means managers are now required to have an institutionalised infrastructure and operational set-up. But what are the challenges facing start-ups? In a conference moderated by Phillip Chapple, executive director at KB Associates, a boutique hedge fund consultancy, and Tom Kehoe, associate director and head of research at AIMA, a number of panellists including end investors, fund managers, lawyers, prime brokers, fund administrators and compliance consultants outlined their views on the issues confronting smaller hedge funds.
Family offices, high-net-worth-individuals (HNWIs) and funds of funds, which have historically been the key sources of early-stage or seed capital for hedge funds, are diminishing in importance much to the frustration of smaller hedge funds. Pension funds, sovereign wealth funds and insurers, many of whom are inherently conservative in nature, are on the other hand expanding their hedge fund portfolios. Stringent risk controls and concentration criteria at these investors often means they cannot gain exposure to smaller managers lest they end up owning the fund, or worse finding themselves invested in a blow-up. Instead these investors tend to allocate to only the larger managers which they perceive to be far safer. In terms of strategies, one prime broker stresses credit, macro and equity long/short hedge funds have been the most popular strategies of 2013, often at the expense of commodity trading advisors (CTAs) whose performance has been poor.
Rising capital requirements under Basel III, curbs on the rehypothecation of client collateral, falling revenues and higher financing costs have all made prime brokerage a far less attractive business to be in than it once was. Small hedge fund managers routinely complain of sub-optimal service at bulge bracket prime brokers, while one audience member acknowledged pointedly that it often felt like it was the privilege of the manager to be selected by the prime broker rather than the other way around. It is no secret bulge bracket primes, as part of their efforts to de-risk and cut losses, are culling unprofitable clients or managers which have struggled to grow their Assets under Management (AuM). When asked whether they had a minimum AuM threshold for clients, prime brokerage representatives from Credit Suisse, J.P. Morgan and SEB denied such a threshold existed, adding their decision to on-board clients was based purely on the calibre of the managers and their ability to grow assets. Some audience members needless to say were not wholly convinced by this answer. A number of primes are also reluctant to work with managers running illiquid or hard to finance assets citing the high financing costs. It has been suggested that smaller hedge funds use mini primes, which are increasingly becoming a presence in London, as their client service is often more bespoke and hands-on. Nonetheless, some institutional investors do view these outfits as high-risk and under-capitalised.
“Balance sheet alone should not be the sole reason for selecting a hedge fund administrator,” according to Ken Sommerville, founder and head of business development at the Dublin-based Quintillion, which was recently acquired by US Bancorp Fund Services. Institutional investors are increasingly urging managers to appoint administrators owned by investment banks irrespective of the quality of service, while some are advising hedge funds not use the same service provider as prime broker and administrator. One prime broker panellist, while recognising investor concerns about using the same bank as prime broker and administrator, believes investors should give cash-strapped start-ups some leeway on this. Another area of contention surrounds pricing and start-ups were warned against appointing any administrator which purports to charge the lowest fees. Stuart Drake, chairman of Equinoxe Alternative Investment Fund Services, describes this as “a false economy,” particularly if the service the administrator offers is not up to scratch or puts off potential investors. Perhaps the biggest challenge facing standalone administrators lies with the EU’s Alternative Investment Fund Managers Directive (AIFMD). Under AIFMD, fully-fledged AIFMs must appoint a depository which will be subject to strict liability for loss of assets while non-EU hedge funds marketing to EU investors through national private placement regimes can appoint a “depo-lite,” an organisation that is exempted from the full ambit of strict liability. Little regulatory clarification has been issued on this matter although it has not stopped standalone administrators from pitching their depo-lite credentials to existing and potential clients. Whether or not regulators permit certain fund administrators to launch depo-lites is still uncertain and there is every possibility the European Securities and Markets Authority (ESMA) could force non-EU hedge funds marketing into Europe to appoint a full depository when it reviews AIFMD in 2015.
Investing in systems and technology is critical. Representatives from Options IT, Capital Support and Edge Technology Group, all warned managers against skimping on costs. Start-ups were strongly advised to adopt a private cloud infrastructure offered by reputable financial technology vendors as opposed to using a cheaper, public cloud provided by the likes of Amazon, Google or Microsoft. “Public clouds may be cost effective but outages can happen and the service levels are not that brilliant,” says one vendor. Business continuity planning (BCP) and disaster recovery (DR) is another area investors are reviewing thoroughly. Having a BCP or DR system in place is one thing, but routinely testing it is another. “Testing the BCP and DR systems is just as important as having the systems in place, so that you can pick up any errors that may arise,” points out one vendor.
The event was aimed at start-ups and it delivered on exactly that. Many of the start-ups present are unlikely to have run a business before, and historically relied on the operational safety net of an investment bank or larger hedge fund. The panel debates did not yield surprises but it certainly gave start-ups a flavour of what to expect as they grow their businesses. Turn-out was impressive although it was geared heavily in favour of service providers.