A Difficult Environment

The going gets tough for small hedge funds in Asia

TANUJ KHOSLA, 3 DEGREES ASSET MANAGEMENT

If somebody ever wrote a book titled ‘History of hedge funds in Asia’ in 2030, I can bet every dollar in my pocket that he (or she) shall refer to 2010 & 2011 as the defining years in the evolution of the industry in this part of the world. Or let us say that hypothetically there was a hedge fund manager with over a decade of experience in fund management who closed down his hedge fund in Asia in 2009 and shifted to Antarctica. If he returns today to start another hedge fund in Asia, he would be faced with totally altered dynamics and shall be as lost as a new trader starting out. The irreversible trends which have emerged in Asian hedge funds over the last few months are expected to completely change the industry landscape in the years to come.

Industry overview
According to some estimates, there are around 1300 Asia-focused hedge funds in the world today with around $125 billion assets under management (AUM). That makes the average size of an Asia-focused hedge fund close to $96 million which is less than half the size of an average hedge fund in the US.

A few more striking facts are:

• 40% of the hedge funds in Asia manage less than $20 million.

• If you arrange the funds in decreasing order of their AUMs, the top 20% manage 80% of the total assets.

• According to Securities & Futures Commission (SFC), 20 funds manage 56% of the hedge fund assets in Hong Kong which has more 500 hedge funds.

Clearly if you are a small hedge fund in Asia, the going is rough. But this is not without reason. A lot of investors have bad memories of fund managers taking various measures to halt redemptions during the financial crisis in 2008. These include ‘tactics’ like putting up gates, side pocketing etc. and many hedge fund investors felt ill-treated at that time. Consequently they don’t feel secure parking their money with new hedge fund start-ups and prefer the bigger and more established names. Asian fund managers on their part refute their allegations stating that despite steady performance investors chose to withdraw their money and ‘treated them like ATMs’. Most claim that they didn’t change the terms and conditions of the original agreements on redemptions during that time.

Whatever the truth may be, the reality today is that hedge funds in Asia which aren’t backed by a big asset management firm (like The Blackstone Group) or seeded by a hedge fund (like Brummer & Partners) are having an extremely tough time raising and scaling their assets. Yet there were 125 new hedge fund launches in 2010, up from 78 in 2009. Clearly in a world in which the US is battling recession, the EU has debt woes and the Middle East is facing civil unrest, fund managers see great potential in Asia. And that is not without reason. Most Asian countries are less leveraged, politically stable and have strong companies that make good products for an aspiring middle class.

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Developments over the last 12 months

Big boys come to Asia
Fortress Investment Group opened an office in Singapore in October 2010. They follow in the footsteps of other industry titans like GLG Partners and Soros Fund Management. Global managers are setting up shops in Asia mainly for two reasons. Firstly, there is strong demand for Asian exposure from their investors. Secondly, they realize that in order to succeed in Asian markets they need to have on-the-ground relationships with companies, boutique investment banks, and regulators. However their focus and presence in Asia is only making it more difficult for smaller hedge funds to raise assets.

Asian funds go West

This is not an attempt by Asian hedge funds to get back at the global managers from the West but a logical step in scaling up. Some 80% of their assets come from non-Asian investors with the US & EU accounting for around three-fourths of these. No wonder that many home-grown funds have opened marketing offices in London and New York and are trying to raise funds citing their ‘local knowledge’ advantage.
Many high profile hedge funds shut down
Even though there have been some high profile start-ups in the last few months, inability to raise funds and/or lack of performance has forced many ‘star’ portfolio managers to close operations.

Regulation

Dodd-Frank Act
President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act on 21st July 2010. According to the Act, funds which manage over $25 million for 15 or more American-based clients will have to register with the SEC by 21st July 2011. As a result they are going to face higher costs due to these increased compliance requirements. The irony couldn’t have been greater for Asian managers. While the West is looking eastwards for growth and opportunities, Asia-based funds find themselves being pulled in the opposite direction due to these regulations that directly impact them.

Volcker Rule
The Volcker Rule bans banks from proprietary trading and investing more than 3% of their capital in hedge funds. In order to comply, banks have disbanded their proprietary desks and spun off their funds.

This is not necessarily a bad thing for hedge funds. Most of the proprietary traders who lost their jobs have either been absorbed by them or have started a fund their own. In fact one of Asia’s most highly anticipated hedge fund launches is the $1 billion Azentus Capital founded by Morgan Sze, the former head of Goldman’s Principal Strategies Group, their proprietary trading unit. The talent pool in the hedge fund universe has increased in quality and quantity as a result of this regulation.

The way ahead
Going forward I foresee the following trends to emerge in Asian hedge funds:

Emergence of Singapore & Hong Kong
Hong Kong and Singapore have doubled in size as hedge fund centres over the past year – at the expense of New York and London. Both cities have been working very hard to cultivate a congenial environment for hedge fund managers by offering light (but not absent by any means) regulation and low tax rates. Hong Kong in particular has received a lot of appreciation from the fund management community for its proactivity. The relatively high standard of living in these places as compared to other Asian cities is an additional incentive for fund managers looking to open an office in Asia.

I expect this trend to continue for three reasons:

• Greater regulations in the West shall make it prohibitive for fund managers to operate there.

• Fund managers shall continue to be attracted by the strong fundamentals of Asian countries.

• Ongoing development of the equity and debt markets in various Asian countries.

In fact, according to some studies, the combined assets under management for hedge funds in these two cities shall overtake those in New York and London by 2025.

Increased role of Compliance Officer
Historically Asian funds have been smaller than their western counterparts. Consequently most of them had the Portfolio Manager or COO doubling up as Compliance Officer to save on costs. But they may have to do away with this practice soon as (a) it may not be permitted under Dodd-Frank, and (b) designated personnel would be required on a full-time basis in order to cater to the regulatory and compliance burden that is going to be placed on these funds. Apart from costs, funds are going to find it extremely tough to find suitable candidates for this role as Asia lacks people with the required experience and skill set.

Super-demanding investors
Between 2003 and 2007, Asian hedge fund start-ups inside a small room with a Bloomberg terminal and two analysts were able to raise hundreds of millions of dollars from investors. That is not going to happen any more. Investors have smarted from their experience in the past and want to see risk-management systems and operating infrastructure in place even before they agree to meet the fund manager. This is a big change in mindset for Asian managers and puts them at a direct disadvantage to bigger funds that benefit from economies of scale.

Minimal lock-ups
Unlike two years ago, investors are no longer willing to have a lock-up on their investments. There are two main reasons for this. Firstly they continue to remain scarred by struggles and frustration they had to undergo in order to redeem their money from fund managers during the aftermath of the financial crisis in 2009. Secondly they want to have the option of reallocating their funds to a different strategy should the market fall out of favour with the one employed by their currentportfolio manager. A ‘star’ fund manager might be able to secure a one to two year lock-up from his investors but by and large funds in Asia will be living on a knife’s edge going forward.

Opportunity for FoHFs
The Madoff scandal almost killed the fund of hedge funds industry overnight. They still remain a dirty word in the US. However I feel they have a big role to play in Asia in the years to come. The reasons for the same are not hard to miss. Consider the following:

• Only 20% of the assets in Asian hedge funds are from Asian investors.

• The number of new hedge fund start-ups has gone up by 60% in the last one year and the average launch size went up to $40 million from $33 million in 2009.

It is not that Asian investors don’t want to invest in hedge funds. However the large amount of information asymmetry that exists between them and the fund managers at a new start-up prevents them from doing so. That is where I feel FoHFs can step in and add tremendous value for both investors and smaller funds.

Asian domicile for hedge funds

For now Asian hedge funds are chained to regulations made in the West but this dependency might reduce significantly as China further opens up its financial market. In such a scenario, Hong Kong is ideally positioned to be an Asian domicile for hedge funds. However I don’t expect this change to take place in the next two or three years.

In conclusion, while big fund names don’t necessarily have better performance than smaller ones, a combination of many factors is going to make the next 12-24 months extremely challenging for the latter. The ones who manage to survive this phase and deliver good returns for their investors are going to stand out.