Advent 6th London Hedge Fund Summit

Reshaping the hedge fund industry after the credit crisis

Originally published in the December 2010 issue

Advent Software held its 6th Annual Hedge Fund Summit on 18th November in London. Participants included Jeremy Charles, chief operating officer, Thames River Capital, Mark Harrison, managing director, European head of prime finance at Citi, Drew Douglas co-head of HSBC Security Services and Joanna Perkins, director, Financial Markets Law Committee. The discussion looked at what hedge funds and service providers are doing to protect themselves from future market turmoil and what impact this is having on managers, prime brokers and administrators.

Jeremy Charles, Thames River Capital: Because most funds have performed well the fact that assets are flat means there has actually been a decline. I also wonder whether we are an industry. Did we lobby effectively on the mess that hit us? Why have we failed to get our story across? I don’t think we are an industry at all. I think we are a series of investment managers who are trying to manage money in a more modern style that the regulator hasn’t caught up with. We are a collection of investment management techniques.

Whatever we think about assets coming in, they are going to have to come back in a different way. Investors want absolute return investment capability. They want managers who can actually hedge and take away the risk. That is demonstrated by the assets that came in. But we have a reputation problem. The industry has to change.

Funds of hedge funds are not very good at showing underlying liquidity. Getting transparency and showing the liquidity we have is fundamental. Counterparty risk is another obvious issue from 2008. What are we doing about demonstrating how we manage counterparty risk? We weren’t very good at getting close to our investors and helping them understand it and the financing. We have to rework the model given the perception out there. I have done many due diligence meetings with investors in the last few years and these have been the fundamental questions from investors.

We have to get rid of the name hedge funds and call ourselves something else. We need to say what a hedge fund does, right at the start: it is there for absolute returns and to provide protection through a large number of different investment techniques. This is what investors are buying: a specific absolute return which can hedge into a structure and strategy that you can’t get from traditional funds. UCITS helps and so do Qualified Investment Funds, while institutions are thinking about re-investing through segregated mandates so they have better protection. It all helps. Our problem is that we didn’t explain our situation very well. We got thumped by much bigger organisations – media, regulators and legislators – who didn’t understand the industry and helped put a dampener on it. That’s our challenge.

Mark Harrison, Citi: With assets recovering to around $1.8 trillion compared with a high of $2 trillion at the beginning of 2008 it sounds like the industry is getting back to where it was. But that doesn’t tell the whole story because leverage levels are significantly down. Though capital in hedge funds is close to being where it was, the actual assets under management are significantly reduced from pre-2008.

We’ve seen several trends. One is continuing institutionalisation of the industry. It means that the asset flows that have come in come into the larger brands. Some of the mega managers have a different set of problems. They have an issue with capacity: how to put all this money to work. There have been fewer start-ups in Europe but with some high profile exceptions. Now we are seeing quite a lot of potential start-ups from prop traders spinning out of the banks. Also, second generation managers, who worked for existing managers started in the 1990s or early 2000s, are setting up their own businesses. The theme through all of this has been investors looking for stability and performance.

From a prime broker’s point of view the thing I would focus on first is the reduced leverage. Financing and stock lending are major income sources for a prime broker. So that has been challenged. We are also faced with a severe competitive environment with 8-10 prime brokers in Europe offering a full suite of services.

Investors have come to us post-2008 asking us for structures to reduce their exposure to the prime broker. We developed Citi Prime Custody. It is a structure to move unencumbered assets in the prime broker into a custody account in the name of the customer. Every night we sweep any unencumbered assets from the prime broker-dealer into the custodian. That way, in the event of the default of the broker-dealer, those unencumbered assets are free and clear. Similarly investors have been talking to us about client money protection for the unencumbered cash in prime brokerage accounts, moving it out and investing it with a series of other banks.

Finally, re-hypothecation is the word no one understood pre-2008, but now everyone does. In order for funds to understand their exposure to the prime broker they have to understand what it is re-hypothecating on a daily basis. All prime brokers are now providing daily reports on the amount that is being re-hypothecated even down to the actual securities being re-hypothecated. Investors are looking for liquidity, transparency and security. They are prepared to forego some performance to get them. They don’t want surprises.

We have spent a lot of time looking at new regulations, most notably the AIFMD which regulates hedge funds and impacts the prime brokers. A year ago it looked so draconian that it could potentially shut some parts of the industry down. It is gone through in a watered down version that the industry can live with. The problem with regulation is that there can be unintended consequences. One that has come up recently is the EU legislation on short selling credit default swaps. One aspect that is concerning is that there is a requirement to report any short sale holding of 0.5% of a company’s market cap and that is against 3% for a long holding. A number of clients who are active in short selling have come to us and said if that is put in place it will effectively close down their strategy in Europe. It means there are financial implications for liquidity in the marketplace. Finally the FSA has put out its Client Assets policy statement which is coming in 2012 and has specific requirements on re-hypothecation and reporting. Also, specific rules related to client money mean you have to put it in 5-6 different banks.

On UCITS, we used to wonder whether it would be a fad or a phenomenon. I think we can safely say it is a phenomenon. UCITS growth has been fairly significant. There are assets of €85 billion in 550 funds.

Finally, a word on the impact of AIFMD on prime brokers. There is a requirement very much similar to a UCITS structure that every fund has to have one depositary and the depositary will sub-delegate to the prime broker. One of the key contentious clauses was the issue of the depositary having strict liability over any sub-custodian loss. It meant that depositaries would have to say there are certain jurisdictions where I won’t let a fund trade because the depositary can’t shoulder the liability. This has now been watered down so that the wording means there is no liability if the depositary can prove that the loss resulted from an external event beyond its reasonable control. As you can imagine lawyers at custodians and depositaries are agonising over this as the discussions go on.