2007: Year In Review

A turbulent twelve months of risk and opportunity

STUART FIELDHOUSE

Asset flows

The year began with a report from Deutsche Bank, based on a survey of 700 investors in hedge funds (of which 90% were direct investors). The survey found the investment community cautiously positive going into 2007, and based on the response, Deutsche estimated inflows into hedge funds of $110 billion in 2007, an estimated 10% increase on 2006.

The US industry was already starting to look a little beleaguered in the wake of the SEC controversy in 2006, with Absolute Return magazine noting that asset raising was down in 2006 versus 2005 (the 86 largest hedge fund launches in 2006 raised $31 billion, the magazine concluded, down $3 billion from 2005).

Hedge Fund Research estimated that Q1 of this year saw $60 billion allocated to hedge funds, setting a new record for the largest ever quarterly inflow, and putting 2007 on track to top the $126 billion it recorded in 2006. "The trend in asset flow suggests that both individual and institutional investors are actively allocating to hedge funds, while the performance indicates hedge funds are exceeding these investors' expectations," said Ken Heinz, the president of Hedge Fund Research. Every strategy tracked by his firms saw net new investment in Q1, with equity-based funds enjoying the largest slice of the pie.

Barclays Capital said it expected alternative investments to become mainstream within the next two years. It was basing its claims on a survey it conducted of 73 wealth managers, just over half of whom said they expected to be increasing their proportion of alternative investments in their portfolios. But Nicola Horlick, CEO of Bramdean Asset Management, said that UK pension funds were lagging behind their counterparts when it came to investing in alternatives. "In the UK marketplace, UK pension funds have been slower than their continental European counterparts to seek the advantages of diversifying their portfolios through investment in alternatives," she said.

The private client market looked like it was starting to wake up to the prospect of alternative investments, with APCIMS, the Association of Private Client Investment Managers and Stockbrokers changing its model growth and balanced portfolios to include a 5% allocation to hedge funds. The FSA consulted the industry on its new retail structure for alternative investments, the Fund of Alternative Investment Funds, designed for private investors to incorporate unregulated collective investment schemes in their portfolios. A formal launch of FAIFs to the UK retail market is expected for next year, and should bring the UK back abreast of France, Germany, and Spain in respect of itstreatment of retail hedge funds.

Regulatory trends

Right from the start this year, the hedge funds industry was crouched under the shadow of the prospect of more regulation or taxation. Suspicions were still rife in European governments that activist hedge funds were a 'bad thing' and the German government unsurprisingly tabled the idea of increased international regulation of hedge funds at the G8 summit this year. Luckily for hedge funds, it seems to have been largely disregarded. The group of industrialised countries has been constantly reviewing the hedge fund sector throughout the year, commissioning the Financial Stability Forum to provide it with reports on just how much of a threat to the global financial system hedge funds represent. Foremost amongst the exponents for the 'light touch' regulatory regime have been German chancellor Angela Merkel, and French finance minister Thierry Breton. "Germany will keep on pushing," Germany's Deputy Finance Minister, Thomas Mirow, told Reuters in April.

Early in the year, AIMA darkly warned that scrapping the Investment Manager Exemption in the UK would make hedge fund managers uncompetitive globally, and possibly force them to relocate. It proposed that the scope of 'investment transaction' be broadened as widely as possible, and include asset classes, like carbon emissions credits that are not specifically excluded by the IME legislation. The risk that the IME could be withdrawn from a whole fund if it carried out a single transaction that falls outside the definition of a transaction was regarded as disproportionate and unreasonable.

Tax has remained firmly on the political and regulatory agenda throughout the year. For fund managers based in the UK, there is an increasing awareness that HMRC is looking hard at their offshore arrangements, and their means of remuneration.

Another major trend has been the convergence between traditional and hedge products, with a number of firms now recognising the potential to offer institutional investors hedge strategies within a traditional fund vehicle, a UCITS III fund, and hence gather additional assets. We also saw an increasing number of houses considering 13030 strategies of one sort or another. Although these do not look set to compete against hedge funds for mandates, and will likely be used to replace long-only funds in institutional portfolios, it was interesting to see not only previously long-only groups launching into this space, but hedge funds as well, on the quest for asset and client diversification.

In April the IMF surprisingly came out against the idea of more regulation for hedge funds, with its Chief Economist, Simon Johnson, saying that "sensible, responsible, macroeconomic policies" by governments were the best protection against instability in the financial markets. "Obviously, there are some particular concerns about whether hedge funds are taking extremely large leveraged bets that could have adverse consequences on banks who might be lending to them," he said. "But we don't see anything in the current situation that would merit a heavy-handed, big increase in regulation across the board of any kind."

For US-based managers, the prospect of increased tax obligations for limited partnerships seemed to be less of a worry, if a survey carried out by CPA firm Rothstein Kass was anything to go by. With Congress considering a proposal that would require limited partnerships to report carried interest as taxable gains instead of income, effectively raising the tax rate from 15% to 35%, the majority of US funds polled for the study were not expecting a substantial impact on the outlook for the industry. "It's apparent from our research that the hedge fund industry is not at all convinced that a tax increase on carried interest is inevitable," said Howard Altman, co-Managing Principal at Rothstein Kass.

Credit crunch and fall-out

There was a strong sense in the first half of this year that markets were starting to become jittery. The short, sharp sell-off in Q1 prompted by the plunge in the Chinese stock-market in late February seemed to indicate that there was already a strong sense of nervousness about where the next systemic shock was about to come from. There were already dark mutterings about the US housing market from some economists in Q1, and some big single manager funds started to put on short positions against the prospect of a sub-prime-inspired sell off at Easter.

In late July of this year things started to go really wrong as the market became confused and bereft of its fixed points, what one manager described aptly as "a pandemic of risk reduction." On 27-28 July, and again on the 16 August, the markets saw their extremes in terms of chaos. With the position reduction came a withdrawal of liquidity, and the previous environment literally disappeared overnight. If the year in markets could be summed up in a footballing analogy, then it certainly was a game of two halves, and the half time whistle had just been blown.

Most hedge fund strategies took a beating over the summer. Some firms proved the exception, and these were frequently under astute managers who had built up a considerable short position in the sub-prime area (Lansdowne Partners being one such).

Some of these funds were able to realise triple figure returns by the end of the year as a result. The sell-off was huge, though, with little regard for strong corporate balance sheets or potential LBO targets. "This stemmed from a wide-scale deleveraging by funds and prop desks seeking to cut expenses and/or raise cash in readiness for prime brokers seeking more collateral," said EIM analyst Liz Chong.

Quant funds in particular were going through somewhat of a trough. They seemed to have converged in their use of similar factors in their trading models. Chong compared the situation to 2005, when convertible arbitrageurs had been left to chase a limited number of trading ideas, and had been wrong-footed by downgrades in the debt of Ford and General Motors. "One school of thought contends that large quant managers nursing losses in their fixed income books sought to raise cash by closing long positions and covering shorts – confusing markets as these trades were carried out at the same time, in a shockingly un-quant way," Chong says.

Christopher Jones, Key Asset Management's CIO, said: "With the quants it was an issue of contagion. We hope quants will learn from this. Certainly, many funds of funds underestimated how correlated these quant funds could be."

All this chaos generated some high profile casualties. One of the first was Bear Stearns, which was forced to write to investors, telling them two of its CDO-based hedge funds were virtually worthless. It began to generate serious questions about the CDO market, and particularly the role of the ratings agencies in the whole fracas. James Cayne, CEO of Bear Stearns, was given his marching orders on 5 August as a consequence of the debacle.

But the panic quickly spread, with BNP Paribas suspending three of its hedge funds on 8 August because the underlying instruments had become impossible to price effectively. Goldman Sachs was the next high profile hedge fund victim, turning to a group of major investors including Eli Broad Hank Greenberg, to bail out one of the bank's biggest hedge funds to the tune of $3 billion. In Australia, the $100 million Basis Yield Alpha fund was served with default notices when it failed to meet demands from creditors.

Towards the end of August, it was becoming increasingly clear that despite plenty of press speculation, the credit crisis had not been cooked up by hedge funds, much as the media would have liked to use them as scapegoats. Scrutiny turned to the investment banks, especially the large Wall Street names that also seemed to have taken most of the hits in the hedge fund space.

Performance

The year got off to a good start, with many managers in positive territory for January. Most managers pronounced themselves, like their investors, cautiously optimistic about the environment. The S&P 500 had had only one negative month in the previous 13 months, and a correction seemed imminent.

However, on 27 February shares dipped around the world when China's stock-market suffered its biggest drop in a decade, down over 9%. Such has been the high degree of optimism surrounding China's economic growth story, that many world markets were hit by heavy selling on the news. Hedge funds rose to the challenge, however. Relative to the S&P 500, the month of February marked the best month for hedge funds tracked by Hennessee since January 2003. Despite most long/short funds maintaining net equity exposures, quality short positions, including a decline in the sub-prime mortgage sector (presaging the even bigger sell-off in August), helped many managers into positive territory. Even in February, it was clear that something was not right in the US mortgage market, with central banks seeking to prune back some of the excessive liquidity in the market.

Hedge funds returned 5.25% for Q2, well up on Q1's performance, according to figures released by Morningstar. Hedge funds slightly underperformed the S&P 500 over Q2, but were up, on average, 7.77% going into July. Emerging markets stood out as the top-performing strategy for the quarter, starting a trend that would see them dominating much of new hedge fund investment going through to the end of the year. Average performance for an emerging markets hedge fund in Q2 was 9.7%, with China-focused funds being a key driver, while strong energy markets helped funds specialising in Brazil and Russia to shine. However, as one cynical fund of funds manager pointed out to The Hedge Fund Journal recently, it was easy for a fund manager to make money on China this year, regardless of whether he had a shorting capability. Indeed, some specialist China managers said it was difficult to make the case for a long/short China strategy when local equities were on such a bull run.

By the third quarter, despite the credit crunch, funds of hedge funds at least were still experiencing net inflows, and those rated by Standard & Poor's were up 1% for the quarter. "After a strong first half, the nine months to end September are now comfortably in double figures and October was another good month," said Randal Goldsmith, Lead Analyst at S&P Fund Services.

"One feature that has been working well for rated funds has been the selection of hedge fund managers who have made money from their short positions…It is reassuring that investors remained confident during a period in which bad news flowed like water from an open tap. However, a fly in the ointment is that all of the net inflows have ended up in one segment: emerging markets/Asia-focused strategies."

"It has been another year of difficult market conditions," says Ian Cadby, CEO of Ermitage, the Jersey-based fund of funds. "If a fund of funds makes 5-6% this year, they will be doing well…The volatility we're seeing is not short-term. The credit debacle is having a meaningful impact."
 


Because of the differing liquidity arrangements fund managers had in place, many were able to invoke emergency clauses to keep money locked up in their funds, and avoid the redemptions of the panicked, or by funds of funds desperate to generate sufficient cash to meet their own clients' redemptions. It certainly served to bring the whole issue of what managers should be allowed to impose in terms of lock-up clauses back to the surface. The fact that some funds of funds were forced to sell managers with decent performance numbers purely because they were offering superior liquidity terms seemed unfair.

Activism

Hedge fund groups again made headlines in the business pressfor participating in both M&A deals as active investors, as well as engaging company management more closely. It was difficult to gauge what shareholders thought of all this, although politicians and some CEOs of the listed companies affected were at pains to complain to the media about their involvement.

Probably the most widely reported example was TCI's role in torpedoing ABN Amro's plans to make further acquisitions, instead turning this around into a demand that the Dutch bank be broken up, thereby setting up a bidding war between a number of other major banking institutions. More recently, a number of hedge funds have ended up on both sides of the Northern Rock rescue plan, with RAB Capital and Monaco-based SRM holding large stakes in the failed building society, and Toscafund playing a part in the group backing the Virgin bid.

Thomson Financial issued a report in November that indicated UK companies were the most likely targets for activist hedge funds in Europe, largely because of the size of the market and the fact that it is politically much harder for activist hedge funds to succeed in continental Europe, especially in the Mediterranean countries, Japan, and emerging markets where governments still have large stakes in many big firms. Even the TCI play at ABN Amro at one point had the Dutch central bank looking at whether it ought to intervene. Interestingly, though, institutional investors lobbied the German government against obstructing legitimate efforts by shareholders to work together against poorly performing management without being classed as a 'concert party.' Thomson itself found in its research that hedge funds were successful in influencing management in 63% of the activist situations it looked at, a relatively high track record.

Currently, concerns still need to be addressed about the level of transparency prevailing in European shareholder registers. One way forward might be a more transparent, EC-backed regime, where hedge funds would need to publicly disclose their holdings and intentions, as the SEC requires under its 13D filings regime.

Listing

Last year, in our review of 2006, this magazine highlighted the growing importance of stock exchange listings for fund managers. Firms have gone to the market this year as well, either listing the management entity or investment trusts. The attraction of 'permanent capital' for managers is obvious, particularly for those who felt investors were unjustly redeeming funds from them in the autumn, simply because they offered superior liquidity terms to competitors.

 

Polar Capital was one of the first firms in 2007 to announce it would be listing, this time on AIM. The $3 billion fund manager said in January that listing was always a long-term strategic objective. "We are at a stage in our growth where it makes sense to go public," said Chief Executive Mark Kary in January. "The listing will enable us to attract and retain talent, as well as develop our brand."

The enthusiasm was being partly driven by the noted success of the Marshall Wace MWTOPS listing in 2006 (the firm raised €1.5 billion by listing on Euronext Amsterdam in December). Amongst others looking to test the waters in Q1 were Jyske Bank, and Brevan Howard, which was considering the listing of a sub-fund.

In the US, Fortress broke the ice by announcing it would IPO in February. The firm's President, Peter Briger, and CEO Wesley Edens, looked set to emerge as the largest shareholders, with 17% and 18% stakes in the company respectively. Nomura had already acquired a 15% stake of the firm, for $888 million, in 2006. Originally founded as a private equity group, Fortress had developed into a substantial hedge funds business, with $9 billion invested in distressed debt and fixed income strategies. Its IPO filing said the listing would help it to "maintain and expand our position as a leading global alternative asset manager…we need people, permanence, capital, and currency. As a public company, we will be best-positioned to meet each of these goals." The shares in Fortress doubled in value on their debut, fuelled by the high profile of the listings, and the enthusiasm of many retail investors, who wanted their own piece of hedge fund success.

In Europe, the Brevan Howard listing created plenty of excitement, coming as it did on the heels of Marshall Wace, and being superbly timed in terms of the market environment. Brevan Howard announced in February it would raise €1 billion via an IPO on the London Stock Exchange for its global macro strategy. "We believe this is the first fixed income/global macro investment company to seek a listing on the London Stock Exchange," said joint-CEO Alan Howard. "Moreover, we believe the London Stock Exchange to be an ideal market to launch such a vehicle."

Part of the attraction to new investors of the listing was that the original Brevan Howard master fund, with $11 billion under management, is closed to new investment. By listing in London, the firm created the opportunity for more investors to buy into the strategy in a more liquid manner. The float was also a coup for the exchange, which was known to be smarting having lost the Marshall Wace listing to Amsterdam. "It is not surprising that Brevan Howard and others are looking to float in London rather than go to Euronext," said Mark James, an alternative funds analyst at ABN Amro. "With the listed funds of funds, there is a depth in the UK market which is not available on Euronext."

The final quarter of the year was less friendly for listed firms, however. The worsening financial climate saw those firms already listed in decline. Flagship private equity group Blackstone, which listed in June in the US, was down 32% at the beginning of December, and Fortress was down 11% from its IPO price. More recent listings, like Och-Ziff Capital Management, and Gottex, both of which went to the market in November, were also well down. One could argue that the time has now passed for further headline alternative investment manager listings. With figures like these, it is less likely that the market will have the appetite, and investors will question whether it might be better to try to invest with the manager, rather than in the manager.

Consolidation

One trend being predicted for 2008, but which was already being played out in 2007, was that of consolidation within the industry. This took many forms, but one was the acquisition of stakes in alternative investment firms by larger entities, amongst them the investment banks themselves. We saw this quite early in the year, when Lehman Brothers said it would be purchasing a 20% stake in Spinnaker Capital. Lehman added that it was planning to raise that stake by 25% over time, as part of a strategic plan to increase its own alternative investment capabilities.

Another big acquisition was that of Citigroup's play for Old Lane, the young hedge fund founded by Vikram Pandit, formerly of Morgan Stanley. The price on the table in early April was $600 million, and was widely seen as a reversal of policy for Citigroup CEO Charles Prince, who had previously described hedge funds as "flavour of the moment." He later went on to pay $800 million for Old Lane, describing it as "an investment as much as it is an acquisition."

CQS, the $8.6 billion UK-based manager, said in September it would be acquiring New City Investment Managers, a deal which would take its assets under management over the $9 billion mark. Michael Hintze, CEO of CQS, said the acquisition was part of his strategy to expand product and geographic reach. Acquisitions of this kind were anticipated going into 2007, as large and established single manager groups tried to diversify themselves into new strategy and product areas by acquiring smaller firms. There is a definite drive towards the creation of more mature, institutional asset management houses with the capacity to offer clients a range of funds benefiting from the same investment culture and infrastructure.

Parallel to this has been the acquisition by a number of players, including investment banks and other institutional investors, of stakes in funds of funds. "There are two or three investment banks out there that want to buy a fund of funds business," says Ian Cadby at Ermitage. "These are hard businesses to build organically."

The search for respectability

The hedge fund industry continued its quest for acceptability in the eyes of both regulators and their political masters. There is an acute awareness amongst larger funds that a political backlash against the sector – along the lines suffered by the private equity industry this autumn – is more than possible in 2008. Punitive tax and regulatory measures in both Europe and the US are all too easily brought into force. With growing levels of institutional involvement in the sector, the industry has started to consider practical means of enforcing higher levels of best practice.

"There is a growing interest in best practices on the part of large and small fund managers," said Eric Roper, Chairman of the Financial Services Group at New York law firm Gersten Savage. "Best practices are becoming more critical to fund management and operations in areas such as director oversight, business continuity, succession planning and employee retention, as well as regulation and compliance."

Best practice groups and publication are proliferating, and include the Hedge Fund Working Group and other similar study groups in the UK, as well as the Managed Funds Association's own efforts, and a new series of due diligence courses sponsored by the Regulatory Compliance Association. Assistant Secretary to the US Treasury, Anthony Ryan, called for sounder industry practices in hedge fund valuations when he addressed the World Hedge Fund Forum in Connecticut in March, including the integration of these practices in risk management guidelines. This is something AIMA has responded too, with the publication of its 'Guide to Sound Practices on Hedge Fund Valuation' in Q1.

Institutional and accredited investors want independent directors to be more involved in the oversight of fund activities, the issuance of manager reports, and a fund's relationship with third party service providers. How directors participate in issues such as conflict of interest and the valuation of non-listed securities is becoming increasingly important. Investors are starting to question whether 'name only' directors really provide oversight, and have started to ask how relationships between directors and fund managers can be improved.

"The need for competent independent directors of funds and management companies, to be actively involved in the ongoing supervision of these entities, has become more compelling," said John Donohoe, CEO at funds consultancy Carne Global Financial Services. "This year became somewhat of a watershed in that regard. In the Bear Stearns case the US courts examined the level of involvement and credentials of the directors. In the UK the FSA expressed the need for higher levels of oversight and control while the Revenue examined the level of offshore management of funds. The credit and ensuing liquidity crises have tested boards and their understanding of key issues, such as liquidity, pricing, investor communication, and above all, risk management."

Forecasts for 2008

AIMA told The Hedge Fund Journal that it would be making its ongoing program of engagement with policy-makers a priority in the New Year. It is no surprise that most hedge fund managers consider political risk to be the biggest threat to the industry in 2008. The Managed Funds Association in the US came in for criticism in 2006 for not being seen to do enough for the industry in lobbying on Capital Hill. By contrast, AIMA has been heavily engagedwith various governmental and legislative bodies throughout the year. It will be focussing on investor education, valuation, market ethics, and governance next year, as well as working closely with its newly established Investor Steering Committee, which includes CalPERS, the World Bank pension plan, and ABP in the US.

Political risks aside, most hedge fund managers are anticipating a recession of some kind in the US at the very least, and possibly further afield as the reverberations of the sub-prime contagion are felt throughout developed world economies. Yet most seem confident enough that this will provide them with further opportunities, particularly if the markets are more volatile. The frenzy for listing will likely tail off in 2008, but we could yet see some more M&A activity within the hedge fund sector, as larger funds and other financial institutions seek to enhance their alternative investment capabilities. Beyond that, can hedge funds keep up their game as activists? They will probably need to be more transparent about their activities, and if they don't jump, will eventually be pushed by European regulators. But a large recession will also spell the end of the M&A frenzy we saw in 2007, forcing them to look elsewhere for alpha.

Will investors maintain confidence in the sector if major equity markets trend downwards? Certainly asset flows into funds of funds in Q3 of this year seem to indicate that, if anything, investors tend to favour hedge funds when markets turn worse – the difficulty of marketing hedge funds to Asian investors in a bull market phase at the moment tends to bear this out.

"I think the rate of start-ups by entrepreneurial types has already slowed down," says Stuart Opp, a partner at Deloitte. "Ten million dollars and a good idea is not enough anymore. It is now harder for start-ups to gain credibility. It is not the end of the boutique manager, but they will continue to feel the pressure. Scale is going to matter more and more. With $250 million under management, you're going to need a middle office and 10-12 people to get that scale." Opp says the credit crisis will mean the big investment banks will be more conservative about which funds they sponsor in 2008.

As for Asia, managers specialising in India are already negative about the prospects for that market, outside real estate perhaps, for 2008. Will there also be a correction in China? That asset flows into Asia funds in Q4 of this year will be repeated in Q1 is entirely likely, but all eyes will be on China, and not just because of the Olympics.