Editor’s Letter – Issue 109

November 2015

HAMLIN LOVELL

EY just released its ninth annual Hedge Fund Survey, from which we have reproduced selected sections in this issue. The survey’s findings will, as always, be intensely discussed, and debated, in forums including EY’s “Global Hedge Fund Symposium” series that take place in 19 cities in North America, the Caribbean, Europe, Asia and Australia between November 2015 and March 2016.

To grow assets, hedge fund managers running under $2bn are most keen to diversify their investor base, with 86% reporting this as a top two priority against just 13% of those running over $10bn. But when it comes to adding new hedge fund strategies, only 20% of sub-$2bn managers prioritise this versus 61% of $10bn-plus managers, reflecting the costs of rolling out new strategies. Indeed, a significant minority of the 110 managers polled for the survey report that new product launches have compressed operating margins or placed a strain on operations and personnel.

Profitability is also pressured by lower management fees – a function of both investors seeking concessions, and managers being willing to give ground. The below $2bn managers are now receiving the lowest fees of 1.33% but even those above $10bn now average only 1.51%. Additionally, some 45% of managers have, or are willing to, negotiate caps on expense ratios, which limit how much costs can be passed through to investors. The story on performance fees is more nuanced. Rather than cutting the headline fees, changes are more likely to involve private equity style features, such as “minimum hurdle rates, tiering of incentive rates, re-investment of incentives and/or crystallisation periods longer than a year”.

Yet many service providers are charging more. Under pressure from various regulations, prime brokers are increasing charges, expected to increase them further, and are coaxing funds into concentrating more business with them whereas hedge funds want to, and are, diversifying relationships by adding more prime brokers and other counterparties. In this dynamic and innovative industry, hedge funds are adapting to the new environment and using less leverage, different types of leverage, or new sources of leverage – such as institutional investors, sovereign wealth funds, custodians or even other hedge funds. Cash balances are also moving from prime brokers to custodians, money market funds or government securities, and this encourages more hedge funds to set up a central treasury function.

To address all of these challenges, and others, hedge funds continue to increase investment in technology to help with most areas of their business. Meanwhile, middle office outsourcing could become a growing trend, though the survey suggests that back office outsourcing has “reached saturation point”.

Much of this continues to create a more challenging climate for start-ups, but reassuringly the survey does report some 54% of the 55 investors polled will allocate to emerging hedge fund managers. Some of these will be showcased in our Tomorrow’s Titans survey in 2016.