Finding Common Ground

E&Y’s Global Hedge Fund and Investor Survey 2012

ERNST & YOUNG

Welcome to this, our sixth and most extensive, survey of the hedge fund industry. We start with a vote of thanks to all those who so generously gave up their time and who made such an effort to respond in depth to the questions. The response has been overwhelming, not only in numbers — 100 of the largest hedge fund managers in the world and 50 major institutional investors with some of the largest allocations to hedge fund assets — but also in the depth, richness and color of the comments and feedback. We believe it makes for our best survey yet as we continue to make our contribution to, and investment in, this varied, vital and vigorous industry. A particular word of thanks to our senior panel of managers and investors, who helped design the questions and shape the survey, without whose depth of understanding of the industry and readiness to participate, this study would not have been possible.

The survey has highlighted some interesting themes, a few of which we note here.
 
First, investor demand is by no means satiated although the investors we spoke to broadly intend to maintain their allocations to hedge funds. Further examination is revealing: a much larger number of investors than anticipated have increased their allocations to emerging and start-up funds, which flies in the face of conventional wisdom that the largest managers are gathering all the assets. More particularly, a significant majority of funds of funds say that they are investing in a “fund of one.” Both these trends attest to a thriving and continually reinvigorating industry. It is difficult to assess whether there is a causal relationship between this trend and a squeeze on margins, but there appears to be conclusive evidence that in each case, funds of funds, as investors, are demanding, and getting, a variety of concessions from fund managers, particularly on fees, and often in return for larger mandates, lock-ups or liquidity restrictions. While the selection criteria of investors and the managers’ perceptions of them coincide far more than they did previously, there remain notable differences between the two groups on what they regard as “red flags” during the due diligence. Poor performance is cited by both investors and managers as being, overwhelmingly, the trigger for redemptions.

Secondly, for the first time and at the request of senior industry figures, we delved into some aspects of the headcount, infrastructure, outsourcing and costs of managers. We might develop this topic more thoroughly in subsequent surveys. Unsurprisingly, the findings show the benefit of economies of scale and how operationally leveraged hedge fund firms are, but the extent of it is remarkable. Full-time equivalents (FTE) in the front office for every US$1 billion of assets under management (AUM) tapers down from 27 for managers below US$1 billion to 4.5 for managers with more than US$10 billion while the back-office slope is even more dramatic: from 32.8 FTE for managers with less than US$1 billion to 4.6 FTE for those with more than US$10 billion. The back to front ratios are interesting, most particularly for managers between US$5 billion and US$10 billion in assets under management. While it tracks at approximately 1:1 for firms with US$1 billion to US$5 billion and those with more than US$10 billion, in the US$5 billion to US$10 billion bracket, it is nearer 1 FTE in the front office to 1.6 in the back. This is partly due to the number of managers in this category with credit strategies, but there are likely additional reasons — the arrival at the threshold of a major build-out; the transformation to running multi-strategies; the need to scale up; and the confidence to re-invest in the business are but a few.

Interestingly, managers are adding to their headcount, most notably in the front office, particularly in the largest firms. The expenses per FTE again demonstrate a clear correlation with size: the largest managers are showing the greater operational leverage. There are some interesting differences between the costs typically picked up by the funds and those that investors think they should pick up. In fact, investors have less appetite for costs to be charged to the fund than they did a year ago. Similarly, investors value shadow accounting very highly but, perhaps unsurprisingly, are less willing to pay for it.

Thirdly, the Eurozone crisis has, where applicable, caused investors to ask a number of questions about exposures, counterparty and liquidity risks, clearing and settlement and, in a number of cases, practices have changed, but there are no signs of a wholesale or permanent withdrawal.

On the regulatory front, the burden continues to grow and the groans do not cease. Managers continue to invest in their regulatory infrastructure, compliance and technology, and costs increase to accommodate the rules. Major intrusions, such as the preparatory work on Form PF, continue althoughits results are unlikely to be widely shared with investors, who remain comfortable that it can be incorporated into the due diligence questionnaire. Most notably, a tiny minority of investors, only 10%, believe that this overwhelming weight of regulation will be effective in protecting their interests and an even smaller proportion believe that they will be of help in preventing the next crisis. This fairly clearly endorses the prevailing view that regulation has now become a self-serving and self-perpetuating industry.

Finally, investors believe that compensation structures are less well aligned with their objectives than managers do. This gap in perception between the two groups has widened over the last two years. Cash compensation dominates, but investors would apparently prefer a greater use of equity in both the management company and funds, accompanied by deferrals and clawbacks. Most markedly, investors feel that a far greater proportion of the assets in the funds in which they invest should be owned by the employees of the manager.

We normally conclude by asking participants to do some soothsaying, and this year was no exception. Both managers and investors feel that there will be a consolidation of funds and managers. This is, of course, true of participants in the asset management industry and, like all received wisdom, should be challenged. It remains true of most members of most clubs that, once admitted, they put up the shutters, restrict newcomers and feel ever more exclusive — which only makes them moribund, a fate that we would never wish on this industry. In order to survive and thrive, the industry will undoubtedly see closures, mergers and takeovers but, we hope, will continue to be refreshed by new and enterprising managers developing innovative and sustainable propositions for investors.

Ratan Engineer, Global Asset Management Leader
Arthur Tully, Co-Leader, Global Hedge Fund Services

INVESTOR DEMAND AND HEDGE FUND SELECTION

The global hedge fund industry is in the midst of a profound transformation. Against lackluster performance, investor expectations and regulatory scrutiny have risen sharply since the financial crisis. We set out to find out what the appetite for investments in hedge funds was under the current market conditions. In this section we explore the following topics:

• Allocation to funds
• Obstacles to allocation
• Fee breaks in return for concessions
• Manager selection criteria
• Triggers for redemption

Survival to sustainability and now, the need for growth from new channels of investors
Notwithstanding lackluster performance, two-thirds of pension funds and endowments plan to stay the course, and another one in five expects to increase hedge fund allocations over the next several years. Investors point to hedge funds’ need to improve risk-adjusted performance and overall high fees as key impediments to increasing allocations. The allure of outperformance has waned as hedge funds’ returns have been far more correlated, and in some cases underperforming, with the overall market.

Given the modest proportion of current investors that expect to increase their hedge fund allocations, industry growth will need to come from new channels of investors that have not yet invested in hedge funds.

The investor conundrum — the prospect for better returns, yet the desire for stability
On average, investors currently allocate 5% to 6% of their assets to emerging or start-up hedge funds.

Funds of funds are far more likely to increase their allocations to emerging or start-up hedge funds than pension funds and endowments.

Investors that expect to increase their allocation to emerging hedge funds point to the prospects of improved performance and negotiating better terms.

“The terms of investment are often far better … and the expectation of better performance in the early years is also greater.”
— Investor (North America)

“[We] prefer nimble managers under certain conditions (pedigree, strategy, market opportunity).”
— Investor (North America)

Investors’ desire for institutional infrastructure and governance suggests that established hedge funds have the ability to leverage their advantages to compete with emerging managers.
 
Fee breaks for larger mandates, emerging managers and the fund of one: the evolving fund of funds business model
This year, more than 90% of hedge fund managers expressed a preference for direct investments from institutional investors over investments from funds of funds. In addition, nearly two-thirds of pension funds and endowments report they prefer to invest directly into hedge funds, half of those through the use of investment consultants.

Managers’ preference for direct investors has been growing over the past several years and is challenging the fund of funds business model. This is not surprising given that capital from institutional investors tends to be “stickier” than capital from funds of funds, which may be faster to redeem when performance does not meet expectations or their own liquidity needs merit withdrawal.

Nevertheless, it is clear that one in three institutional investors — and over 50% in EMEA — still rely on funds of funds for their hedge fund investments, at least in part because funds of funds have been more successful in negotiating fee breaks and special terms.

Selection criteria are continuing to become more aligned, yet people and process, not just performance, are paramount
Hedge fund managers continue to point to long-term performance as key in selection, and overall, the top five criteria they point to remain the same as last year’s — even as the gap among the top five criteria has narrowed.

A hedge fund’s management team continues to be investors’ top concern, followed by risk management and clarity of a manager’s investment philosophy. Only then does past performance enter the list.

It is interesting to note that hedge funds still believe recent investment performance is important more often than investors do. Although investors clearly look at past performance (long-term and current), confidence in the people who will generate future returns is more important, and confidence in the processes that will appropriately manage risk-taking is at least equally important.

Transparency continues to be important to investors. Leading hedge funds have shown that transparency means more than reporting on holdings and performance and now differentiate themselves from peers by communicating proactively and providing high levels of access to key personnel during due diligence.  

Performance is a key trigger, but the lack of proactive and transparent communication of change and risk is an equally important reason for redemptions
Performance will always be a key factor that investors consider when deciding to remain committed to a manager.

However, investors place a heavy emphasis on the continuity of the investment team and operational risk (particularly funds of funds) whereas managers are less likely to see them as contributing factors to redemptions. Instead, managers are more apt to point to market risk (that is, changes in the market dictate reallocation of investments).

Investors remain wary of operational failures on the part of hedge funds. Although most managers surveyed have already developed an infrastructure to mitigate many of these concerns, managers would be wise to ensure they actively communicate aboutchanges in personnel — including their plans for long-term succession — and the operational controls they put in place to mitigate disruptions.
 
“Investors will always track performance, look at the firm’s reputation, operational strengths, clear segregation of assets and systems risks, strong internal compliance systems, lack of conflicts of interest and lack of frequent staff turnover.”
— Hedge fund (Asia)

“They look for anything involving integrity, ethics and code of business, making sure that you have an untarnished background, not just as an investor, but with people you’ve worked with — reputationally. Also, and this is increasingly important, depending on your size, not investing in your business operations would be a red flag. It’s important for them to see that you’re investing in the business, in your systems, in technology, in your operations.”
— Hedge fund (EMEA)

HEADCOUNT, INFRASTRUCTURE, OUTSOURCING AND COSTS

Increased regulation and investor scrutiny have resulted in significant changes in how the industry operates, increasing costs for compliance, regulatory reporting and other infrastructure areas. These increases and the trend toward outsourcing and shadowing, are elevating costs and resulting in margin compression. We set out to find out what investments hedge fund managers were making on the people, process and technology fronts.

In this section we explore the following topics:

• How much has the cost of running a business changed?
• Where are managers making headcount investments?
• Where have capital expenditures to technology been made?
• Which functions are likely to be outsourced?
• What are the perspectives on shadow accounting?
• What costs are being passed on and what are investors’ reactions?

Nearly half of hedge fund managers say the cost of business has increased in the past year
Nearly half of hedge fund managers globally say the cost of running their business has increased, but a higher proportion of managers in North America — nearly 60%, compared with 44% in Asia and 36% in EMEA — say their costs have increased.

This is not surprising given recent changes in the regulatory environment in North America. The primary drivers cited by the respondents for these cost increases were additional infrastructure (headcount and technology) to meet the regulatory burden and improve risk management and increases in personnel to keep pace with the growth of the business.

Those managers that decreased costs cited better expense management (particularly among managers in EMEA), increased outsourcing, technology efficiencies and reductions in headcount to correspond with decreases in AUM and exiting from certain strategies.

For those whose costs have increased over the past year, the average increase in costs was 15%.
For the managers who decreased costs, the average decrease was 21%.

There are clearly economies of scale as firms become larger
On average, the hedge fund managers who were interviewed employ approximately 11 front-office personnel and 13 back-office personnel per billion dollars of AUM.

There are clearly increasing economies in both the front office and back office as firms become larger and achieve scale. The AUM at which efficiencies are realized vary according to the strategies employed by the funds.

Economies in the back office are not as consistent as they are in the front office. Hedge funds between US$5 billion and US$10 billion AUM appear less efficient than hedge funds between US$1 billion and US$5 billion because a higher proportion of these funds offer credit or distressed strategies. These strategies are back-office intensive, and therefore, critical scale is not achieved until they become much larger. Efficiencies are regained when AUM exceeds US$10 billion.

Overall, hedge fund managers in Asia have yet to reach critical economies of scale relative to hedge funds in other regions at least in part because they remain smaller. Hedge funds in EMEA appear highly efficient, largely because that segment is overweighted to equity long and short strategies.
 
Yet hedge funds are adding headcount across the front and back offices to support growth…
Nearly two in three hedge fund managers have either added headcount in the front office or expect to in the near future, largely to support asset growth and expansion into new strategies. A number of managers say hiring has been opportunistic, particularly given the upheaval at banks. Overall, roughly 40%–45% of hedge funds are adding headcount in support functions — middle office, back office, risk management and legal and compliance — to support expected growth, client demands for transparency and the increased regulations.

Though the largest hedge funds are actively investing in technology and looking to increase outsourcing, a higher proportion of these managers are adding headcount in the middle and back offices to accommodate growth. These findings suggest that a meaningful proportion of hedge funds continue to operate inefficiently, under-leveraging technology and outsourcing solutions. As the industry continues to see consolidation, additions to the front office are a trend that will likely continue. It is critical that hedge funds build a scalable operating model to support such growth in an efficient manner.

…even as they make capital investments in technology across functional areas
In addition to headcount investments, hedge fund managers are making technology investments to support both the front office and back office.

More than half of hedge fund managers are making technology investments in risk management, compliance and investment management systems. A significant number are also investing in sales support systems and client reporting. The need for consistency in data across risk, compliance, marketing and investor reporting makes the technology spend critical in this regulatory environment.

Investors generally recognize the value of these investments. Two-thirds say that their managers need to invest in risk management technology, and nearly 60% say their managers need to invest in investment management systems.

Unsurprisingly, the one clear point of divergence is that relatively few investors think that
hedge funds need to invest in their marketing-support systems, but would rather see the investment in client reporting systems.
 
Few managers see opportunities to increase outsourcing
Few managers have identified opportunities or willingness to outsource more than they already have. Over 70% of hedge fund managers do not expect to increase outsourcing in the next two years. Half of those that do expect to outsource further point to middle-office and back-office functions.

The majority of investors noted that it would be unacceptable for the hedge funds they invest in to outsource front-office or risk management activities, and although some express concern about outsourcing middle-office functions, the majority see managers’ operations and legal and compliance functions as acceptable for outsourcing.

The findings suggest that outsourcing may have reached a saturation point. However, in light of continued scrutiny of fees charged by funds, managers may want to re-evaluate opportunities to outsource as outsourcing providers continue to develop their service offerings and demonstrate successful track records.
 
Increased shadow accounting in the past year?
Nearly 90% of the hedge fund managers in this year’s study perform shadow accounting on at least some functions, a marginal increase from 84% last year.

One in four said this year that they had increased the amount of shadowing they do. As managers add strategies to grow, the volume of processing and accounting they shadow increases. However, we don’t believe that managers are shadowing new processes.

In light of the greater focus on fund expenses and the shrinking margins of most managers, the industry will need to coalesce around an industry standard that is both cost-effective and within a reasonable risk tolerance.

The challenge will be to develop an effective oversight and shadowing structure that recognizes the cost efficiencies of using an outside administrator while providing both managers and investors with confidence in the areas outsourced.

Investors value shadowing, but just over 50% say it is worth the additional costs if passed on to the fund
Though it is virtually a must in today’s market to employ an independent administrator to maintain a fund’s books and records, most managers elect to maintain a significant degree of in-house operations to oversee their administrators.

Investor perceptions reinforce the value of this oversight. Nine in 10 investors believe that shadow accounting is highly beneficial to accurate valuation and reporting.

Though almost 90% of investors say shadow accounting is beneficial, only half say it is worth the additional costs if passed on to the fund. Interestingly, pension funds and endowments are more likely to say the benefit outweighs the potential cost than funds of funds investors are. This is an area that is constantly challenged and may not, in all cases, be a license to pass on the cost of shadowing to the fund. Typically, passing additional costs to the fund increases downward pressure from investors on management fees.
 
To respond to cost pressures, hedge fund managers are passing on an increasing array of costs, but investors are becoming less tolerant
Despite the increases in the cost of running the business, 90% of managers say their management fees adequately cover the expenses of the management company.

This is due in part to the fact that hedge funds have increased the costs being passed along to the funds over the past year, particularly in the areas of regulation and compliance. Fewer than half of the investors believe that the management fees should cover such expenses.

To the contrary, there are certain costs that have been under a great deal of scrutiny when passed along to the funds. In particular, 80% of investors believe the costs of shadow accounting should be covered by management fees, and generally, the hedge funds are less likely to pass on the costs to the funds than they were a year ago.

There will continue to be a push and pull on this issue for the foreseeable future as investors increasingly believe that many of the costs currently passed on to the funds should be covered by the management fee even as the cost of doing business in the industry increases.

“Better management of expenses is the key driver, but we also did some outsourcing, which contributed to the decrease in the cost of running the business.”
— Hedge fund (EMEA )

“Main drivers for the change in cost were infrastructure build-outs for capital expenditures in investment management systems and risk management.”
— Hedge fund (North America)

EUROZONE CONSIDERATIONS

We set out to find out how the Eurozone crisis has impacted the industry, what changes, if any, managers have made to their business and operations and whether they meet the investors’expectations.

In this section we explore the following topics:

• What concerns investors most about the Eurozone crisis?
• What questions are investors asking?
• What changes have been made by managers due to the crisis?
• What changes do investors want managers to make?

The focus is on counterparty exposure, safekeeping and access to liquidity
Over half of the investors are highly concerned with operation-related risk, such as their hedge funds’ exposure to European counterparties, as well as to changes in where cash is held.

More than two in five are concerned about exposure to currency redenomination and any resulting market impact.

Over half of the hedge fund managers report that investors are asking them a number of questions about the response to the Eurozone crisis. Clearly, investors are concerned about the financial viability of European banks and financial institutions.

Investors in EMEA are generally more sanguine about these issues than their counterparts in North America and Asia.
 
Hedge funds are evaluating operational and market risks

Interestingly, half of those investors that are very concerned believe their managers still need to take action to reduce exposure to European counterparties.

Though many managers have determined to make minimal or no changes in response to the Eurozone crisis, more than 30% have changed where cash and liquidity are held. Of these, a higher proportion of the largest funds have made changes. And, on balance, managers are trading with fewer counterparties and allocating business to European counterparties perceived to be stronger.

A high proportion of managers are confident that their risk management is sufficient to manage their exposure.

Interestingly, 53% of managers in EMEA have reduced exposure to the Eurozone, compared with fewer than 40% in North America.

Just over 5% of managers say they have increased exposure to the Eurozone. These managers view the crisis as an opportunity to invest, widening bond exposure to Eurozone sovereigns and expanding trading in foreign exchange.

Managers should be more actively communicating to their investors to ensure they are aware of the steps managers have already taken to manage risk.

“The Eurozone crisis has made us more tactical in how we trade and at times have lowered our risk levels — especially when we have less conviction in our trading ideas. Over certain times this year, we have had a risk view and have expressed this as short euro-exposure and short equities to take advantage of this view.”
— Hedge fund (North America)

“I think managers should be thinking about counterparties and settlement arrangements and contingencies routinely. They shouldn’t be looking at the Eurozone crisis in particular. They should be looking at those things wherever they operate around the world.”
— Investor (EMEA)

REGULATIONS AND REPORTING

The regulatory demands on the hedge fund industry have increased significantly. The industry is feeling pressure to reduce its opaqueness to alleviate investor and regulator demands and concerns. These requirements are forcing managers to change the way they manage their operations, as well as increasing the cost of doing business.

In this section we explore the following topics:

• What significant changes have regulations forced managers to make?
• What changes do investors expect managers to make?
• How effective are regulations at protecting investors’ interests and preventing the next crisis?
• Views on Form PF?

Hedge fund managers expect regulationsto force investments in compliance and technology and result in higher costs
At most hedge funds, compliance is ultimately responsible for regulatory reporting. With the increasing burden of regulatory reporting, it is not surprising that a majority of hedge fund managers have invested or are investing in compliance functions dedicated to reporting.

A key area for investment has been in technology and data management to facilitate reporting.

Investors also expect increased costs because of regulation, and they fear these costs will be passed directly on to the funds. But, beyond the additional costs, 20% expect that regulations will force hedge funds to rationalize their product offerings and increase transparency.

Yet few investors perceive regulations as effective in protecting their interests or preventing the next crisis

Despite a number of regulatory initiatives since the financial crisis — mandatory registration, AIFMD and Form PF — few investors, and far fewer than two years ago, believe that regulations will be effective in protecting their interests.

Furthermore, 85% of investors don’t believe regulations will be effective at preventing the next crisis.

Investors in EMEA are less cynical. Just one in four investors in Europe says regulations will be ineffective at protecting their interests versus nearly two-thirds in North America.
 
Effectiveness of Form PF is in question, and a majority of managers do not intend to share the form with investors
Most managers do not intend to provide the complete Form PF to investors, and investors are generally on board, provided that relevant information from the Form PF is incorporated into the manager’s due diligence documentation.

It would be prudent for managers to refrain from providing the actual Form PF for a variety of reasons.

First, the information requested by the SEC is meant to be used to identify systemic risk and reported at the manager level. Therefore, it may not be meaningful to investors.

Second, the interpretation of the requests and certain information provided by managers will vary from entity to entity, so comparisons across institutions will be of limited value. Given the varying interpretations possible, the reported information will likely require a detailed explanation of assumptions and detailed footnotes about disclosures.

Finally, the data presented in the Form PF may not align well with typical investor reporting.
 
“We have spent some money to build out a centralized data warehouse to make sure the data is consistent and that we are able to process it on a timely basis. It’s to make sure that what we are giving clients, regulators and internally is timely and consistent across the board.”
— Hedge fund (North America)

“I expect to see more transparency in the form of better disclosure of policies and, therefore, fewer conflicts of interest. However, I don’t see the regulations being helpful at preventing the next crisis because crises are unknown. Regulations are basically meant to solve last year’s wars.”
— Investor (North America)

“Because of regulation, we have been forced to register in a number of different jurisdictions around the world, even where we don’t have a physical presence. We are doing some outsourcing in this area, using more local regulatory consulting firms.”
— Hedge fund (EMEA)

COMPENSATION STRUCTURE

Our 2010 survey showed gaps between managers’ and investors’ perceptions of how compensation should be aligned with risk and performance.

While the gap in views oncompensation structure is not new, we wanted to find out if there had been efforts at reconciliation between the two groups.

In this section we explore the following topics:

• How well compensation schemes match investors’ expectations
• Views on senior executives’ annual compensation
• General partners’ and employees’ stakes in the game

Hedge fund managers still perceive greater alignment in compensation than investors do
Though fewer hedge fund managers say their compensation scheme aligns performance of front-office personnel with investor objectives than in 2010, the vast majority continue to see strong alignment.

Investors are also less likely to say compensation schemes align interests very well than they were in 2010.

Compensation — a key issue for both managers and investors — appears no closer to being resolved because it has not caused material hedge fund redemptions. Moreover, it is not one of the key impediments to increasing allocations to hedge funds, nor a key consideration in choosing a hedge fund.
 
Investors would like less cash compensation for senior executives…

It comes as little surprise that there has been little progress in alignment on compensation. Over two-thirds of hedge funds say that their compensation structure has not changed in the past three years. Just 14% say that less is paid in cash, and just 10% say that compensation is subject to longer deferral periods.

On average, nearly 75% of senior executives’ compensation is paid in cash — a similar proportion to that of 2010. Investors, by contrast, say less than 40% of compensation should be paid in cash. They would like to see a larger proportion paid in equity and deferred cash, subject to clawbacks.

It is unlikely that this gap will be closed in the near future. Since the prohibition of offshore deferrals, the types of available tax structures that make it more mutually beneficial for both the investor and manager are significantly diminished.
 
…and want the GP and employees to have more skin in the game
Overwhelmingly, investors would like to see deferral periods of three years or more, and three in four investors say they strongly believe that hedge funds should employ clawbacks. Few express concerns that this could limit a hedge fund’s ability to recruit talent.

Furthermore, investors clearly want employees to have a larger stake in the success and failure of a hedge fund than they currently do.

“For trading and portfolio management personnel, more of their compensation is tied to trading performance and a smaller portion is based on overall performance.”
— Hedge fund (North America)

“Portfolio managers eat what they kill and a few are partners and also get small equity.”
— Hedge fund (North America)

FUTURE LANDSCAPE

Many hedge fund managers are reacting to demands put on them by institutionalizing their operating models, reducing fees, providing more reporting and expanding risk management. All of these have increased the cost of doing business in a time period when alpha generation has been a challenge, resulting in an overall decrease in revenues and a squeeze on profit margins. We asked managers and investors what they thought were the biggest trends.

In this section we explore the following topic:

• Biggest trends in the industry in the next two years

The perfect storm: increasing regulation and accompanying costs with lower fees are forcing consolidation
Hedge funds expect consolidation and increased regulatory oversight with its accompanying costs in the next few years. A number recognize the continuing downward pressure from investors
on fees. Investors also expect consolidation and clearly will continue to pressure managers on fees.

Increasing costs and continued downward pressure on fees mean a perfect storm for hedge fund managers that will force consolidation — particularly for managers that have not reached critical mass in assets under management — and increase the barriers to entry for the small and nimble start-ups that some investors clearly seek out.

Of course, the stress of increased cost and downward pressure on fees would be mitigated by outstanding investment performance over the next several years.
 
“More bipolarization — the big players will get bigger and will be more institutional in nature — more like asset management shops; the small are likely to consolidate to survive. Increased regulation costs and requirements will be a burden for smaller firms.”
— Hedge fund (Asia)

“Managers have to re-invent themselves. That’s because the market will be so benign, and what with extra regulations, they just cannot achieve their historical performance. I do see a consolidation in the market; the mavericks and niche players will disappear.”
— Investor (EMEA)

“Fee compression in that higher fees justify exceptional performance, and if you can’t deliver exceptional performance, you’re going to have a hard time justifying higher fees and your fees are going to have to come down.”
— Investor (North America)

BACKGROUND AND METHODOLOGY

The purpose of this study is to record the views and opinions of hedge funds and investors worldwide. Topics covered in the study include manager selection, administration, regulation and reporting, compensation structure, infrastructure, fees and expenses, Eurozone considerations and the future of the hedge fund industry.

Greenwich Associates conducted:

• One hundred telephone interviews with hedge funds from July to September 2012, representing more than US$710 billion in assets under management
• Fifty telephone interviews with institutional investors (funds of funds, pension funds, endowments and foundations) representing more than US$715 billion in assets, with over US$190 billion allocated to hedge funds.