Institutionalisation of investors and regulation taking toll on hedge funds, according to AIMA/KPMG report
Approximately 98% of hedge funds have increased investment in regulatory compliance since 2008 as new rules continue to take their toll and the industry becomes ever more institutionalised, according to a joint report by KPMG and AIMA.
Of that 98%, 26% had made at least two new hires while 45% said they would appoint more staff to cope with the additional compliance workload going forward. The report highlighted such costs would invariably hit the smallest managers the hardest. Several respondents complained overhead costs would significantly rise.
Managers said new regulation, particularly in the US, could potentially lead to an increase in litigation claims, “which is a big cost and a big unknown.” Others expressed frustration at the regulatory arbitrage “which is leading to confusion and duplication of efforts.”
“Since the crisis, hedge funds globally have been forced to register and report to their national regulators. However, different regulators require different information meaning there is no uniform process. Form PF in the US, for example, requires managers to submit their Regulatory Assets under Management (RAuM) which accounts for leverage and the notional value of derivatives positions. Other regulators, however, just require AuM as it is normally. A lot of managers are confused by all of this arbitrage among regulators. The recent short-selling bans imposed by several eurozone states is another example of regulation not being joined up as different countries imposed different restrictions,” said an industry source.
Furthermore, regulatory delays and shifting deadlines often make it difficult for managers to plan and execute their regulatory compliance plans. Form PF deadlines have been pushed back from January 2012 to December 2012 while there is still no firm date for implementing mandatory clearing of OTC derivatives on either side of the Atlantic.
“There is huge regulatory uncertainty at the moment among managers, particularly around what the final rules will look like and when they will be implemented,” said Robert Mirsky, head of the hedge funds group at KPMG. “Rules such as AIFMD, FATCA and MiFID II are nearing their implementation dates but managers do not know what the specifics of these regulations will look like. Managers also have not spent much time preparing for these rules. In Europe, a lot of managers are still unsure about what they need to do in regards to Form PF and FATCA. I suspect a lot of managers are relying on their fund administrators to do the hard work for them. Many managers are behind the curve in sorting out their compliance programs to ensure they are in sync with global regulation,” he added.
Costs have also surged following the rapid institutionalisation of investors post-2008. According to the survey, 57% of the industry’s $2 trillion plus AuM is derived from institutional investors. Pension funds have also been boosting their exposures to alternatives with 76% of respondents reporting an increase in pension fund investments. The woes of funds of funds, however, continues with 70% of respondents seeing a decline in these vehicles’ allocations.
Investor demands, particularly in operational due diligence, have grown substantially since the crisis with nine out of ten managers reporting increased investor due diligence. Meanwhile, 82% said investors had become tougher on transparency. Hedge funds have taken note as 84% stated they had bolstered transparency with their investors.
“During 2008, a lot of high net worth individuals exited hedge funds although this capital has been replaced since by institutional money. Inevitably, this has led to hedge funds being subjected to tough due diligence and transparency requirements with managers having to focus on areas like risk management and corporate governance. Managers have had to change the way they operate to ensure they meet these institutional investors’ criteria for investing,” said the source.
This institutionalisation of the investor base has ultimately contributed to bifurcation in the hedge fund industry. Pension funds and insurance companies, which have strict risk criteria, binding concentration limits and substantial ticket sizes, are often required to allocate to the biggest, brand-name shops. A survey conducted by J.P Morgan’s Capital Introductions Group revealed 67% of pension funds and 57% of insurance companies will only consider managers with a minimum of $250 million AuM.
However, funds of funds, high-net worth individuals and family offices still embrace boutique managers. The KPMG/AIMA survey said funds of funds are twice as likely to invest in a manager with less than $500 million than a $1 billion plus outfit. Historically, funds of funds acted as access vehicles to hard closed funds although they have re-evaluated their model and are now focusing on niche strategies or emerging managers following horrific underperformance during the crisis.
An AIMA source said smaller hedge funds were optimistic. “We found smaller managers to be more optimistic than we would have anticipated. This is a resourceful industry and many are adapting and evolving, or using different structures and models to compete. This is an industry which has always been quick to respond to change, and those managers which respond quickly will be the ones to benefit,” said the AIMA source.
There has also been an emergence of “co-opetititon” among boutique players whereby managers, who traditionally would have been competitors, are forming mutually beneficial working relationships . “Co-opetition might entail hedge funds sharing a platform whereby the platform takes care of all of the back office and marketing work leaving the managers to do what they do best and trade,” said the AIMA source.
In terms of geography, 77% of managers reported a surge in capital inflows from the Middle East, followed by Asia-Pacific (69%), North America (68%) and the European Union (53%). Switzerland was the only country to experience a decline (56%). However, the EU results are skewed because the majority of allocations represented in the survey are derived from the UK and the Nordics.
“A lot of Swiss investors during 2008 got burned by their hedge fund allocations because of bad performance while a few unlucky investors had exposures to Bernard Madoff. I do believe there will be a turnaround shortly although this is dependent on what the changes to Swiss hedge fund regulation will look like,” said Mirsky.
The survey polled 150 hedge funds globally with more than $550 billion in combined AuM.
Written by Owen Dickinson