Managers need $300 million to break-even, according to Citi Prime Finance

Prime Brokerage
10 Dec, 2013

Hedge fund managers need at least $300 million in Assets under Management (AuM) to enable the management fee to cover their operating costs and regulatory requirements, according to Citi Prime  Finance’s 2013 Business Expense Benchmark survey. 

Firms with less than $300 million will struggle to pay for management company costs such as third party expenses, salaries and compensation without additional capital or incentive fee pay-outs. In Citi’s 2012 survey, it estimated hedge fund managers running under $250 million spent approximately 198 basis points of their 2% management fee on operations and third party service providers alone.

This increased expenditure is mainly attributable to the onslaught of global regulations on both sides of the Atlantic. Under Dodd-Frank, hedge fund managers must supply the Securities and Exchange Commission (SEC) with the highly-forensic Form PF document, and the Commodity Futures Trading Commission (CFTC) with a Form CPO-PQR. Meanwhile, in the EU, managers are facing the Alternative Investment Fund Managers Directive (AIFMD), a regulatory initiative which BNY Mellon calculates could cost the average hedge fund manager anywhere between $300,000 and $1 million.

“The increased costs are predominantly due to the inherent complexities of operating across multiple EU countries and the overheads associated with regulation. A lot of hedge funds have been hiring personnel to help with regulatory compliance and accounting. I do not believe costs will, however, grow much more significantly because managers have adapted to the change already, and the growth in expenditure in 2013 over 2012 reflects that,” said David Moss, head of EMEA business advisory at Citi Prime Finance in London.

Total compliance spend by firms with $100 million in AuM was 18 basis points, half of which covered internal compensation for compliance personnel while the other half was spent on third party outsourcing and software charges, said the Citi study. It added firms managing between $500 million and $10 billion spent between three to four basis points on compliance.

A study conducted by AIMA, the Managed Funds Association (MFA) and KPMG of 200 managers running more than $910 billion in AuM estimated the total spend by hedge funds worldwide on regulatory compliance was $3 billion.  The study – The Cost of Compliance - found the average spend on compliance at small fund managers was approximately $700,000; $6 million at mid-sized funds, and $14 million at large hedge funds.

These added costs come as fees - the traditional 2% management fee and 20% performance fee – have been under severe investor pressure amid several years of desultory returns. The Citi Prime Finance survey said management fees had fallen to as low as 1.58% for all but the largest hedge funds. It added firms with $500 million in AuM, after paying expenses, would realise operating margins of 69 basis points, rising to 82 basis points for hedge funds managing more than $900 million.  

 “Fee compression continues to reshape the business of hedge funds, lowering fees even as expenses rise, all but eliminating fee-only operating margins, and raising the level of assets needed for a hedge fund business to succeed. And while it is clear that there is little room for additional downward pressure on management fees, at current average fee levels, investor-manager interests are well aligned – both parties are focused on performance,” said Alan Pace, global head of prime brokerage and client experience at Citi Prime Finance.

The Citi study revealed geographical divergences too with European managers seemingly far more concerned than their US counterparts about the implications of regulatory reporting with the SEC and CFTC, not to mention the soon-to-be-implemented AIFMD.  Mandatory clearing of OTC derivatives and FATCA were also cited by European managers as areas of concern.

US managers, while focused on Form PF and Form CPO-PQR, are not devoting as many resources to AIFMD compliance despite a number of these firms having clients in Europe. However, AIFMD restrictions on marketing and remuneration are stirring debate in the US with some managers contemplating their future within the EU.

“Some US managers are considering holding off marketing efforts in the EU because of AIFMD. If you assess where the hedge fund flows are coming from it would be fair to say 70% to 80% are from US institutional investors,” said Lou McCrimlisk, senior relationship manager for global markets at Citi. Given the lack of investor appetite among European institutions in hedge funds, a number of US managers are conducting cost benefit analysis to determine whether compliance with AIFMD makes economic sense.

Asia-based managers “seem to have the least level of regulatory concern, even about the rules coming into play in their own region. These managers express the most concern about AIFMD but only see that as having a moderate to significant, not severe, impact on their organisations. SEC/CFTC registration, compliance and reporting are seen as even less concerning with even FATCA coming up as only a mild area of focus,” read the report.

However, some believe the costs associated with regulation will be a short-term issue as managers get to grips with onerous reporting requirements. Several COOs contacted by COOConnect all confirmed the time spent compiling and collating the required data sets for Form PF had fallen dramatically since their first filing. McCrimlisk acknowledged managers would inevitably familiarise themselves with regulatory reporting but said there was nothing to stop new rules being pushed forward by legislators and regulators down the line.

Citi Prime Finance polled 124 hedge funds globally with a collective AuM of $465.4 billion.