The challenges facing emerging hedge fund managers are well-documented. The sheer volume of regulation following the financial crisis has had a significant impact on the hedge fund operating model. Rules such as the Alternative Investment Fund Managers Directive (AIFMD), the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive II (MiFID II) are all going to ramp up the costs of doing business in the European Union.
Meanwhile, the Dodd-Frank Act subjects managers to additional reporting obligations, and indeed centralised clearing of over-the-counter (OTC) derivative transactions. In addition, the industry is rapidly institutionalising. As such, these institutional allocators expect institutional standard infrastructure, which can of course be costly for a start-up or emerging hedge fund. In short, establishing a hedge fund is not a straightforward undertaking anymore.
The days when a hedge fund could launch with $5 million in capital and minimal infrastructure are long gone. In fact, the 2014 Citi Hedge Fund Industry Operating Metrics Survey said managers needed to run at least $310 million in Assets under Management (AUM) to enable their 2% management fee to cover all of their operating and regulatory costs. This represents a drop from $330 million in the same Citi survey conducted in 2013. Other papers reach similar conclusions – a survey conducted by KPMG, the Alternative Investment Management Association (AIMA) and the Managed Funds Association (MFA) of 200 managers globally with $910 billion in AUM found a third of managers running less than $250 million said their compliance spend accounted for 10% of their operating costs. While this figure does appear somewhat high, the crux is that setting up a hedge fund is not an inexpensive exercise. But that is not to say nimble hedge funds offering an intelligent, differentiating strategy are unable to launch or attract money. This paper looks at some of the challenges, and opportunities facing emerging hedge fund managers during the capital introduction stages in this post-financial crisis landscape.
Regulatory challenges around marketing
The AIFMD has imposed a number of requirements on hedge funds, including restrictions around remuneration and the obligation to appoint a depositary bank to provide cash-flow monitoring, safekeeping of assets and oversight of the fund subject to strict liability for any loss of assets. But one of the biggest challenges it brings is its restrictions around marketing. There are several mechanisms by which AIFMs (any fund manager that is not regulated under UCITS) can market to EU investors. The first approach is for a fund manager to become a fully compliant AIFM and avail itself to the pan-EU passport, which theoretically permits managers to market without restriction to institutional investors across the 28 member state bloc. A fully-compliant manager must appoint a depositary bank and not a depositary-lite, the latter of which performs all of the depositary duties but is not subject to strict liability. A fully compliant AIFM with more than €100 million leveraged is also only required to file a single Annex IV, the detailed regulatory report required under AIFMD, with the regulator in which they are based, as opposed to all of the jurisdictions they are marketing into.
However, as passporting a UCITS fund has shown, some member states have gold-plated the rules, and introduced additional hurdles for managers. For example, a UCITS manager is required to appoint a local paying agent and a local information agent if they market into Germany or Switzerland, whereas they must appoint a centralising agent if they market into France. Furthermore, Germany and Austria subject UCITS managers with marketing operations there to additional tax reporting requirements. This all adds to the challenges and costs of raising capital in the EU.
The second mechanism by which to attract institutional money is to market into the EU through national private placement regimes (NPPR). NPPR simply means a fund manager has to comply with the rules in only the countries it is marketing into. A number of US managers with a heavy bias to UK investors are simply complying with the UK rules as these tend to be more favourable. Unlike other jurisdictions, the UK does not require hedge funds to report details of both its master and feeder fund in Annex IV. The UK’s Financial Conduct Authority (FCA) has also introduced proportionate remuneration rules. NPPR does require managers to supply multiple Annex IVs to the regulators in the jurisdictions in which they are marketing. Again, some regulators are requiring firms to answer voluntary questions within Annex IV although divergences at present are minimal. The big challenge again is gold plating of the rules. Germany and Denmark, for example, require non-EU managers of non-EU funds to appoint a depositary-lite if they are raising capital in those two jurisdictions. Using NPPR requires managers to appoint legal (and tax) counsel to ensure compliance with the various private placement regimes, and this can add to costs.
The third method by which to attract capital is the somewhat counterintuitive concept of “reverse inquiry” or “reverse solicitation.” In the most basic sense, this is waiting for investors to contact the fund manager through no inducement and encouragement by the fund manager. Firms hoping to avoid the compliance costs of AIFMD – which BNY Mellon estimates could initially be anywhere between $300,000 and $1 million – have been advised to rely on reverse inquiry.
However, it does pose practical challenges and risks. Firstly, the definition of marketing in the Directive is all encompassing. AIFMD describes marketing as “any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in an AIF it manages to or with investors domiciled in the EU.” Lawyers have repeatedly warned managers about what may or may not constitute marketing. Some conservative general counsel have advised against even distributing business cards to EU institutions lest it be deemed marketing. Others have been advised to make their websites harder to access in certain jurisdictions where the risk of regulatory censure is higher. One law firm suggested that managers could have to explain to regulators if an EU institution increases a pre-existing capital allocation. The risks of breaching the marketing rules are potentially quite great. The penalties for violating the rules include a regulatory fine and the associated reputational risk would be worrisome. Furthermore, if a manager breached the marketing rules and successfully attracted capital from an EU institution and made misjudged investments, that investor has right of rescission for any lost assets accrued through mis-marketing. Ultimately, managers have to document thoroughly any interactions they have with pre-existing or prospective clients. Having strong and effective regulatory compliance policies and practices in place is essential in this new regulatory environment.
While AIFMD does make marketing into the EU more onerous, it can be done. Firms need to think carefully about how they want to comply with the Directive in order to solicit EU capital.
Switzerland has long been one of the most attractive capital raising destinations for hedge fund managers in Europe. Home to an abundance of private banks, funds of hedge funds, family offices, high-net-worth-individuals (HNWIs) and ultra-high-net-worth-individuals (UNWHIs), Switzerland has a long history with the alternatives industry. However, new rules are making it harder for launching or emerging hedge funds to market into Switzerland. The Collective Investment Scheme Act (CISA) required foreign funds distributing to qualified investors to appoint a Swiss legal representative and paying agent as of 1 March 2015. CISA was introduced to bring Switzerland into line with the EU’s AIFMD. A qualified investor is defined as an entity with CHF5 million. Failure to appoint a paying agent exposes managers to a number of risks. A failure to appoint a paying agent means any fund marketing activity that is directed at either prospective or existing Swiss investors is illegal and subject to criminal sanction. If a generic email outlining market trends find its way into the inbox of a Swiss investor, this is construed to be illegal marketing absent the appointment of a paying agent. However, managers are still able to privately place their investment vehicle to private banks although they must be cognisant of the risks that marketing materials could be inadvertently leaked to retail clients. As such, private banks will be cautious about interactions with these managers.
Fund managers can rely on reverse solicitation. As with AIFMD, the issue is that smaller fund managers could struggle to gain meaningful traction among the investor community. It would also expose managers to potential regulatory risks if authorities construed interactions with Swiss investors to be tantamount to marketing. Another is to rely on private banks, but the best option is probably to appoint a legal representative. The costs can be quite significant. Estimates suggest there is usually a fixed cost of between CHF3,000 and CHF4,000 for the first fund, and CHF1,000 for every fund thereafter. As with AIFMD, managers have to gauge whether the cost economics of distribution make sense in Switzerland. Nonetheless, the Swiss market – having been hammered by Bernard Madoff, and other frauds – is regaining its confidence in alternatives and should not be written off.
The rules on marketing into the US, which is the most mature hedge fund market globally, are not as onerous as those in the EU. For firms marketing to US investors with at least $150 million in AUM, they are obligated to file the Form PF and supply it to the Securities and Exchange Commission (SEC) periodically depending on AUM. However, to be exempt from registration and take advantage of US private placement rules means a non-US manager cannot sell its product to more than 35 investors in a 12 month period. Therefore, managers have to be careful when sending out mail-outs and organising meetings in the US. Furthermore, the SEC is in the midst of changing the rules on what constitutes an accredited investor. At present, individuals with an annual income in excess of $200,000 and a net worth of more than $1 million can be defined as qualified investors and can invest in private funds such as hedge funds. Nonetheless, this might change as Section 413 (b)(2)(A) of the Dodd-Frank Act states the SEC must review the threshold for accredited investor every four years. There is speculation as to what the SEC intends to do. There is a possibility the SEC could introduce financial competency tests to ascertain whether an individual is actually accredited and understands the products they are buying. Quite how feasible this would be is open to debate.
However, the SEC has made it no secret that it would like to increase the accredited investor threshold given the current thresholds were first introduced more than 25 years ago and it has not taken into account for inflation. There is a strong possibility the SEC will reform it. In 2010, the SEC said an individual could not include their primary residencein their net worth. It is also well documented the SEC is nervous about unscrupulous fund managers targeting investors following the passage of the JOBS Act, which permits private funds to market and advertise their product publicly. Quite how much the SEC will increase the threshold for accredited investors is hard to guess although some lawyers say it could increase the annual income requirements to $500,000, and the net worth requirements to $2 million. If this were to happen, it could become much harder for start-up and emerging hedge funds to target HNWIs. It would also make it harder for smaller managers, many of whom are dependent on seed money from friends and family.
Who are the investors and what do they want?
The challenges around marketing hedge funds do not appear to have facilitated a reduced investor interest in the alternative asset class. In fact, nearly all industry surveys appear to indicate that growth is set to continue. The latest data from Hedge Fund Research in Chicago indicates hedge funds globally manage $2.94 trillion. Credit Suisse Prime Services’ survey of hedge fund investors found allocators forecasting a 14.4% increase in hedge fund industry AUM over the course of 2015. If these projections are correct, hedge fund AUM would exceed $3 trillion for the first time. Investors are certainly maintaining this enthusiasm. A similar study by Deutsche Bank Markets Prime Finance found 39% of investors planned to grow their hedge fund allocations, of which 22% intend to invest an additional $100 million into hedge funds. An oft-repeated comment about hedge funds is that the industry is rapidly institutionalising with public and private sector pension funds, investment consultants and insurance companies making up the bulk of these inflows. There is truth to this of course. Pension funds, struggling to reign in massive deficits, are moving beyond bonds – some of which have negative yields – into alternatives, which can allow for diversification and decent risk adjusted returns.
Data has repeatedly shown that smaller managers deliver superior returns than their larger peers, mainly because they can enter and exit positions, particularly in niche or bespoke markets without impacting prices excessively. PerTrac, a data provider, highlights smaller managers (defined as a hedge fund with less than $100 million AUM) outperformed mid-sized hedge funds (defined as a hedge fund with $100 million to $500 million AUM) and large hedge funds (defined as a hedge fund with more than $500 million AUM) in every year since 1996 bar 2008, 2009 and 2011. PerTrac found that since 1996, the cumulative return for the average small manager was 558% while mid-sized firms generated 356%, and larger managers 307%. Large allocators are noticing this recognition of smaller manager outperformance. 53% of investors told the Credit Suisse study that they would most likely allocate to hedge funds with an AUM of between $250 million and $1 billion. They cited the fact these fund managers were not capacity constrained and were capable of taking advantage of smaller market opportunities. Other surveys reach a similar conclusion. Preqin said 39% of investors would put money to work in a manager running less than $250 million, while 21% are willing to seed a fund. Operational due diligence personnel are also enthusiastic about emerging fund managers with 68% telling a 2014 Deutsche Bank study they would allocate into one. However, there is a caveat insofar as investors are more likely to veto an emerging manager than an established shop.
Private capital is also making a strong comeback, according to various industry surveys. Private capital derived from institutions such as private banks, family offices, wealth managers, HNWIs and UHNWIs is returning to hedge funds. A study by the capital introductions arm of Goldman Sachs in 2014 found that private capital accounted for 22% of the $2.7 trillion controlled by hedge funds, a noticeable increase from 17% in 2012. Interestingly, the same survey found institutional money had failed to grow for the first time since the crisis. Much private capital had retreated from hedge funds amid several years of underperformance following the crisis, and the imposition of gates and side-pockets by managers as market liquidity vanished. Others were unfortunate enough to be invested in frauds such as Bernard Madoff. This all dented private investor confidence in the hedge fund industry markedly. However, this negative attitude does seem to be subsiding. The bulk of this private capital is derived from North America (55%), according to Preqin. This is followed by Europe (31%), and Asia-Pacific (11%). The latter region is witnessing immense growth in wealth, and is increasingly looking beyond property to hedge fund managers to look after their money. In short, there is a substantial amount of capital out there waiting to be allocated. Having an effective introducing broker to facilitate and initiate meetings between managers and prospective investors is absolutely essential.
But what do managers need to demonstrate to these investors, both institutional and private, in order to win capital allocations? In an era of disappointing year-to-date (YTD) returns of 3.08%, hedge funds must differentiate themselves in terms of strategy and performance if they are to successfully solicit meaningful capital from institutional and private investors. Aside from performance and strategy, managers must have a developed operational infrastructure that is of institutional standard to appeal to operational due diligence teams. The clout of operational due diligence at investors should not be underestimated in any way. A Deutsche Bank study conducted in October 2012 found 66% of investors spent between three months and six months conducting operational due diligence on prospective managers compared with just 33% in the pre-crisis heyday of 2003. 70% of operational due diligence teams also have veto powers over prospective hedge fund managers. As such, it is essential managers have systems and processes in place that meet the standards of these allocators. Operational due diligence teams told a Deutsche Bank study in 2014 that fund expenses was a top concern with 64% acknowledging they would scrutinise erroneous expenses. 38% said valuation policies and procedures were of the utmost importance. Compliance unsurprisingly featured highly too in the Deutsche Bank study. Other prerequisites for fund managers include having quality technology infrastructure in place, segregation of duties and skilled personnel.
All of this costs money. There is intense pressure on hedge fund fees – the traditional 2% management fee and 20% performance fee – and this can cause challenges, especially for a firm hoping to start-up. But there are mechanisms by which managers can reduce their overheads. Outsourcing is one of them. There has been a growing acceptance amongst investors of outsourcing. Many had historically feared managers risked losing control of key functionalities. This is by and large an out-dated view. More than 94% of investors tolerate the outsourcing of compliance, middle office and IT support at emerging managers, according to the 2014 Deutsche Bank study. A majority (58%) said it is acceptable for emerging managers to outsource their trading. This is a welcome development. Managers too have traditionally been apprehensive about outsourcing their trading desks for fear that their prime brokers would not offer them the same quality of service as they were executing trades elsewhere. This is not an issue anymore. While outsourced trading desks are common in the US, it is something that appears to be gaining traction in Europe.
Outsourced trading desks not only save emerging managers enormous costs of having to employ dealers, which can be up to $1 million collectively. This does not take into account of costs such as staff bonuses, installing and maintaining Bloomberg and other market data feeds, order management and trade execution systems, post-trade obligations, and any regulatory reporting obligations that go with it. In addition, outsourced trading desks help ensure best execution, which is now becoming a regulatory requirement courtesy of the MiFID II. Furthermore, outsourced trading desks will cover all geographies and asset classes, and use best in breed technologies. Outsourced trading desks will also have no proprietary positions – again something that should provide peace of mind to fund managers. In an environment where returns and investors are hard to come by, fund managers must demonstrate that they are using best of breed providers to help them deliver the highest quality of service to their investors.
Jerry Lees is Executive Chairman of Linear Investments – Prime brokerage, execution and Hedge platform services including FCA incubation and Capital Introduction. Lees founded the electronic trading and Prime Broking business of CA Cheuvreux, and was the original founder of businesses at the beginning of the global cross border DMA industry, involved in FIX from the outset and founder of multiple successful technology and financial businesses.
Capital Hungry Hedge Funds
Post-financial crash challenges and opportunities
JERRY LEES, EXECUTIVE CHAIRMAN, LINEAR INVESTMENTS
Originally published in the June | July 2015 issue