An Industry On The Growth Path

PwC's Pars Purewal on coping with change

Originally published in the March 2008 issue

In December Putnam Lovell, as part of its strategic analysis of the future of the fund management industry, predicted that alternative assets were destined to become mainstream via extension strategies and transparent long/short portfolios. Combined, products now described as ‘alternative,’ will represent slightly more than 50% of industry revenue within five years, the specialist investment bank predicted. It points to massive growth within this sector, including in hedge funds, going forwards.

At PricewaterhouseCooper, where Pars Purewal has recently taken up the reins as Head of its Alternative Investments Practice, these figures are an indicator of just how important alternative investments are destined to become within the asset management industry. PwC has already measured approximately 10% growth in assets management by alternative specialists, including hedge funds, in 2006 alone, and is predicting this will double over the next three years.

The move to congregate the various alternative practice areas – real estate, private equity, hedge funds – is also being replicated at PwC’s competitor across the river in Canary Wharf, where KPMG has pooled its alternative investment resources into a single Alternative Investments Group under the auspices of Tony Rocker. It makes sense to start managing alternatives under one umbrella, partly because many investors approach them this way, and partly because many fund managers are starting to diversify across the boundaries between alternative asset classes.

The big consultancies are recognising that the funds they advise, regardless of the area of investment they operate in, are facing many of the same challenges, much of it driven by remarkable growth, including the commitment of billions of dollars in new investment from institutional clients. Private equity funds, the argument goes, are sitting in a very similar boat to hedge funds when it comes to the regulatory and operational challenges they have to grapple with.

Purewal sees Europe and Asia in particular enjoying rapid growth, with 40% per annum compound in the regions’ hedge fund industries. Not only that, but these industries are experiencing a high level of convergence with other alternative investment ‘silos’; witness the involvement of hedge funds in private equity-style deals, where the manager is typically taking a sizeable stake in a company, above and beyond that required for exposure to the appreciation of the share price.

According to Purewal: “At one level, it is activism, because the manager is seeking to influence the price, but it also involves taking a slightly longer term view. We’re seeing some hedge funds holding stock for three to four years, this is not just short term activism.”

Hedge funds are now using the tactics of their private equity brethren, drawing up strategic plans that involve making substantial changes to the businesses they invest in, and getting to grips with the management of firms in more proactive ways.

An industry grows up

Other common issues shared by alternative investment managers include operational and business-related challenges, for example the sorts of offshore structures they use, the taxation issues they face, and the desire the founders of these firms have to realise value from their businesses. Hedge funds are still a relatively young industry compared with real estate or private equity, with many fund groups having track records of less than 10 years. The substantial growth has occurred since 2001, and it is only now that some founders are considering their exit strategies.

“CEOs are going to have to start asking themselves how they are going to realise the value contained in their firms”

This is an area where firms like PwC have increasingly been called on to advise partners on their options: do they list the company, do they sell out to a large bank or asset management firm, or do they seek a strategic partner which will acquire a significant stake? “Hedge funds are having to start to behave like the more traditional players,” explains Purewal.

The publication of the Hedge Fund Working Group’s code of conduct for hedge funds is also raising the bar, requiring firms to be more transparent, and put in place formalised systems and controls that might not have been prevalent previously. These requirements, coupled with the heady growth figures, are leading CEOs to turn to Purewal and his colleagues for help. Larger hedge fund groups, those with an institutional client base and ambitions to increase the range of strategies they offer, and building up a strong asset management brand in the process, are grappling with corporate-level issues that they did not need to worry about when they were formed, perhaps as an LLP, to manage private wealth assets.

Institutional investors are going to start asking what a hedge fund’s strategic objectives are, says Purewal, and CEOs are going to have to start asking themselves how they are going to realise the value contained in their firms.

Building larger, multi-strategy firms is also exposing hedge fund owners to growth challenges which PwC is increasingly being called in to help with. In addition, some of PwC’s existing asset management customers are looking at ways to meet client demands for hedge funds internally. The easiest solution, says Purewal, is to find the appropriate team, and hire them in, complete with a ready-made track record, but it can be hard to find the right team, and to negotiate appropriate lock-in conditions.

“Building internally from scratch takes time, but some institutional fund managers feel they can’t afford to wait,” says Purewal. “The challenge is, do you integrate them completely as part of your organisation – and some hedge fund managers will resent that – or do you leave them as a stand-alone shop?”

In addition, institutional fund managers bringing a hedge fund ‘in-house’ will have to think carefully about how the portfolio managers are to be incentivised. Acrimony can also occur if the parent fails to deliver sufficient assets to the fund via its distribution network, and fee earnings are paltry as a consequence. Some big fund management groups, used as they are to levying annual management charges only, find it hard to get to grips with hedge funds’ performance-related culture. “To be successful, this requires the alignment of corporate desire with individual desire,” Purewal says.

Political risk

Going into this year, while many senior figures in the hedge fund industry were optimistic about funds’ ability to cope with turbulent markets, and even a recession in the US, the political risk scenario was creasing some brows. At the root of this was the concerns raised in the UK parliament and by UK trades unions about the role of private equity funds in the nation’s economy, as well as criticisms of hedge funds by senior German ministers at the G8 summit last year. The industry needs to be worried, says Purewal, although he sees any ‘threat’ more likely to manifest itself in the form of an increased regulatory burden than higher taxation of hedge fund partners. “With 80% of European hedge funds based in London, if the government wants to keep them here – which they will – they will carefully consider the situation, and take a softly, softly approach.”

Purewal thinks the industry can help itself by providing more discovery and transparency, and slaying a few of the ugly myths that surround it, including a reputation for taking high-risk bets (not helped by the collapse of Amaranth after it did just that). “Many hedge funds are adopting safe strategies,” says Purewal. “They’re not shooting the lights out, they’re aiming to beat a benchmark, yet many people in the financial services industry still have no proper appreciation of hedge funds.”

One of the big trends in global asset management in 2008 is going to be the increasing adoption of ‘hedge-lite’ strategies by established groups that are keen to retain client assets. Bringing in some form of short component to funds that invest in liquid markets, it is hoped, will allow managers to contain risk more efficiently, and hopefully enhance returns. The advent of 13030 strategies or 12020 for that matter, will bring some of the benefits of long/short funds to the conservative European institutional investment market.

At the same time, hedge fund groups themselves are looking at UCITS 3 structures, which since November will allow UCITS funds far more flexibility in what they invest in, as a means to access institutional capital pools across the EU. In addition, regulators and retail finance groups are studying the blueprints of regimes that will permit the marketing of retail funds of hedge funds. It all makes for an exciting cocktail of change from the perspective of the consulting industry.

“If you’re moving into the UCITS arena, if you’re dealing with retail exposure, even if indirectly, you’re looking at far more onerous regulatory requirements,” says Purewal. “They’ll be tougher and tighter than anything hedge funds have experienced before, and any hedge fund provider in that space will have to have their eyes wide open.”

Ahead of the curve

PricewaterhouseCoopers has positioned itself to serve the hedge funds industry via its global network of offices, and strong European legal and regulatory practice. It regularly convenes its European leadership team to help it anticipate which areas its clients will most likely need help on, and it is this process that has already flagged up the UCITS issue for 2008. PwC is even starting to consider the likely form that UCITS 4 will take, when it eventually arrives!

“Clients seek our advice because we have the skills and the knowledge to be able to add value,” says Purewal. PwC has over 300 personnel in the UK alone working in the alternative investment space, including audit. “We’re growing our numbers as our practice grows. There’s hardly a day goes by that we won’t get approached to tender for a new fund.”

Like other big consultancies, PwC aims to cover as many different areas of advice for hedge funds as it can, ranging from tax structuring for both corporate entities and individuals, through to FSA authorisation, and help with the selection of an administrator. But this is just the beginning: teams can also support and review internal systems and processes, provide audit services, and further down the line help managers to realise their investment. If they choose to IPO, PwC can work with lawyers and prime brokers to ensure this goes smoothly.

As a practice, PwC has always tried to stay slightly ahead of its clients by anticipating their demands. This can often take the form of research projects carried out via the client base in an effort to glean vital additional insights into what fund managers will be asking for two or three years down the line. In the business of advice, it is no use reacting to demands as they happen: it takes too long to build up the requisite internal expertise.

For PwC, one of the obvious communities to tap for feedback has been hedge fund investors. Their future demands, the reasoning goes, will determine what hedge fund managers’ future requirements will be. Purewal is already picking up a desire by investors for more transparency from hedge fund managers, and better communication, to a degree that the industry has not been used to previously. “Investors want more transparency from their alternative investments…there is a desire amongst investors to have a better understanding of what the manager is doing, of what the risk profile is. They feel this is something they should reasonably expect.”

He sees larger pension funds starting to develop their own internal hedge fund expertise, rather than rely on the views of external human resources consultancies. There is an appetite for more exposure across all types of alternative investments, but in order to facilitate that, trustees are having to make their own hires to ensure that they are receiving the appropriate advice.

Credit crunch

As for the credit crunch, and the disappearance of much of the liquidity from global markets which has concerned many of his clients, Purewal says it is still too early to fully gauge the impact on alternative investment firms. “Over the first quarter, as the reporting cycle reaches its conclusion, we’ll be able to start to gauge its impact,” he says. “We’ll begin to find out how hedge funds have performed in reality. There remain widespread concerns about the valuation of some underlying assets.”

Part of the problem, he thinks, lies with the level of sophistication of the illiquid instruments some funds have acquired exposure to. “The processes that have been adopted in some cases have not been good enough, and a lot of work is going to be needed to support their valuation. Certain guarantees are going to need to be given. It is early days yet, and we’ll have a better feel for things by the end of March. Some hedge funds have suffered from this already, but there will probably be more casualties. It is hard to say how many, but I don’t expect it to be a huge number.”

What of the massive swathe of redemptions it was expected that hedge funds would be facing at the end of last year? Purewal says some funds have been dealing with a “reasonable” level of redemptions, but some have been able to defer these. To what extent the deferrals have been accepted, and whether investor confidence in the manager and the markets he trades returns in time, remains the real issue. “I still foresee a net inflow into hedge funds,” he says. “This industry is on a growth path.”


Pars Purewal is the UK Investment Management and Alternatives Leader at PricewaterhouseCoopers. He has over 20 years of experience within the investment management sector and is a member of the PricewaterhouseCoopers Global and European Leadership teams with direct responsibility for developing its service offerings to the alternatives sector in the UK. Purewal is responsible for a number of PricewaterhouseCoopers alternative investment clients and is experienced in addressing issues such as listings, governance, fund structuring and audit. He has also worked on a number of M&A transactions in relation to alternative asset managers.