On The Record

IBA Private Funds Conference: The Future of Hedge Funds

Originally published in the April 2010 issue

Emerging Trends with Investors, Regulators and Managers

Mike Schmidtberger, Partner, Sidley Austin
Martin Byman, Co-Head, European Prime Brokerage, Morgan Stanley
Mark Barker, Chief Investment Officer, Hermes BPK
Victoria Younghusband, Partner, Financial Markets Group, SJ Berwin
Martin Keller, Head of Institutional Finance, Europe & NA, Man Investments

Mike Schmidtberger: We will discuss emerging trends in the industry over the last 18 months, touching on managed accounts, funds of funds and prime brokerage. We’ll talk about what investors want and discuss some regulatory and practical implications. Each panellist will give a few thoughts on recent developments from their unique perspective in the industry.

Martin Keller: If I look back over the last two years, the ultimate question from an investors’ vantage point is whether hedge funds have actually failed investors over the particular cycle we’ve seen since 2007 and, overall, in the long-run. So is the hedge fund value proposition still valid? If you look back two years – post-Madoff and the peak of the credit crunch there has been some very negative thinking about hedge funds. So the question remains: are hedge funds still a valid proposition? From that starting point we see a couple of themes emerging. One is that hedge funds actually are not an asset class. We see the emergence of long-short equity being treated as an equity substitute and investors allocating to hedge funds outside the alternative investment or hedge fund bucket in their portfolio. Is that a sustainable trend? We clearly see significant changes in investor behaviour. The flight to liquidity and focus on control and transparency has shaped the industry over the last 18 months to two years and will continue to do so.

Managed accounts have taken a very prominent place in how investors implement hedge fund allocations. One of the bigger questions for me, given Man’s large fund of funds business, is how fund of funds provide value. Will, for example, fund of funds grow and prosper or is the future going to be about hedge fund allocations going directly into single managers, either into limited partnerships or managed accounts?

We see ongoing consolidation. Also institutionalisation of the hedge fund space is something that will continue. It will shape the industry and what it takes to be a meaningful player and a successful hedge fund solutions provider in the future. From a Swiss vantage point, I see (hedge fund) migration from London to our beautiful country arising from tax (issues). I can assure you we are very friendly and welcoming!

Mark Barker: I found myself in a rather peculiar position as I was on gardening leave as the crisis broke. I had stopped working a couple of weeks before Lehman collapsed and sat on the sidelines before coming back in mid-December 2008 to put the Hermes BPK fund of funds business together to launch in January, 2009. It was a fairly daunting prospect and I spent a lot of time wondering what have we got ourselves into? Is this industry going to survive? Clearly, at the time, the hedge fund industry’s reputation was in tatters with Madoff, side-pocketing and everything else. With all the things that took place it became clear that our partnership with Hermes, a flag-bearer for the corporate governance movement, gave us a historic opportunity. The hedge fund industry had, as a result of superior out-performance over a very long period, created a sort of supply and demand imbalance, where the wants and needs of the investor were somewhat secondary to the wants and needs of the hedge fund manager.

There was a level of opacity and arrogance that came with the success of the industry. And the abilityfor investors to make demands on their manager other than – ‘Give me the set of returns that I’m looking for’ – was limited. The end of 2008 re-aligned the model, the supply and demand balance changed completely and there was a dramatic attempt by managers to re-associate themselves with institutional investors. And that has been the catalyst for a series of changes that are taking place in the industry. There is an opportunity for institutional investors to engage with managers in a way that they haven’t done before. And we very much use the word ‘engage’ rather than ‘prescribe.’ I think there have been one or two attempts by institutional investors to say ‘this is how it must be done’ and lay down a set of rules, which may not have been terribly successful. But, because managers were forced to sit down and listen to their investors, there was a realisation that they might not have served the industry or their investors that well. And there was a desire to change that balance, to be more open, to be more transparent, to work with investors and to generate greater alignment.

That’s really where the industry heading: better aligning of the needs of the investor with the manager. I think if investors take more of a consultative approach when they engage with managers they can achieve much more. The fund of fund industry was probably even more challenged than (single manger) hedge funds. It clearly got a number of things very wrong. Asset- liability mismatch on liquidity is something that will haunt the industry for a long time and it needs to be addressed. Many of the more professional fund of fund managers have addressed it. One way is to change terms for investors. A second way is to look at structures such as managed accounts in order to create better look-through on liquidity and higher confidence of meeting redemptions. I think, overall, the governance bar for investors has been raised and this is where the hedge fund industry needs to deliver. If fund of funds deliver transparency, demonstrate responsibility and meet investor expectations, then there is business there and the industry can move forward.

Victoria Younghusband: Looking back over the last 18 months and possibly even before then to the summer before Lehman collapsed people were already concerned about the terms of their prime brokerage agreements and looking at the rights of re-hypothication. On prime brokers, hedge funds have moved from one prime broker to several. On the governance theme, the Hedge Fund Standards Board was actually working on the principles prior to Lehman and came out with them later that year.

Clients now are looking for full due diligence, both operational due diligence and legal due diligence. What goes hand-in-hand with increased regulation is the flight towards funds which are regulated and are seen as being good for investors and actually good for managers if they can get their strategies in them. Last week, the Irish Financial Industry Association attracted 500 people to a UCITS III conference. The Irish financial regulator said you could do virtually anything within a UCITS. Now, you might think that’s not entirely a good thing. But it’s a good thing for managers insofar as it should mean under current regulation that they escape the rigours of the Alternative Investment Fund Manager Directive. It’s a sort of get out of jail card if you can have a regulated fund, though (it requires) an independent custodian, independent valuation and an independent administrator. (UCITS) offers not only distribution within Europe but easy access to Asia and Latin America. It is a very big trend. (On regulation) I think the hedge fund industry was caught on the back foot and has a lot of work to do to show that (firms) are well-managed and that (funds) actually deliver very good returns to investors.

Martin Byman: Prime brokers (PBs) work with hedge funds. Fundamentally, we clear, we settle, we finance hedge funds’ trades, we provide technology to them, everything post-trade, so that they can look at their portfolio from virtually an infinite, variety of perspectives, including risk, margin and performance. We make their life easy in just about every area we can think of (such as) proxy voting and dividends. The overall goal is for the portfolio to focus on performance on investment, and we will, together with, typically, a COO or a CEO, do the rest. That’s the core of prime brokerage. Over time, and for competitive reasons, most PBs have added what they call ‘value-added services,’ and there’s three to note. One is we help our clients look at risk and there’s also a whole business set up to help clients start up, find real estate, find technology, even, relevantly for this group, help them a bit with registering with the relevant regulator. And most prominently, help clients with capital-raising. All of those value-added businesses have grown over time.

The contrarian view is that, although there have been some changes in the hedge fund model and the prime brokerage model over the past 18 months, they haven’t been fundamental changes and, frankly, I’m not sure they need to be. If you ask the average institutional investor today to look at their portfolio, I bet you 80% of them will say the strongest performance and the happiest scenarios are coming from the hedge fund industry. Performance was poor in the hedge fund industry in 2008, if what you’re expecting is an absolute return, but if you’re expecting overall out-performance over time, the hedge fund industry has delivered. When we look at our client base, which is predominantly equity-based, as of last month, approximately 60% of our clients were above their high watermark, so from July 2008 to today, most of them are up. You won’t find many strategies or asset classes where that’s true. If take the part of the hedge fund industry that (Morgan Stanley) tend not to deal with a lot – CTAs, macro and fixed income – it’s even better. There has been a lot of talk about gating and suspension of NAVs, and clearly there was some of that, but fundamentally, there’s less than you might think. For those of you who practise law and deal with hedge funds, you may have seen a lot of that, but that’s because the clients who come to you are the ones who were dealing with those issues. But, fundamentally, we look at our client base across the board. Most of them had the following thing happen. About half their investors said: ‘We want our money back.’ Guess what: they wrote the cheque in accordance with the terms of the offering documents. The result, and to me, this is the biggest change in the industry today is that it’s smaller. A lot of repercussions flow from that. One is there may be more opportunities for performance. Second, it also means that the supply-demand imbalance discussed earlier has changed a bit. But it’s not a by-product of guilt or anything that went wrong, it’s just that when there’s less money chasing the same number of opportunities, perspective changes. Overall, I’d say our client base is not arrogant. I think they’ve tried to do the right thing whenever possible and it’s a good investment proposition for investors.

As a lawyer, I feel that the last 18 months has put me at the centre of a four-ring circus. In one ring, were the government regulators, the CFTC and SEC, states attorney-general and stock exchanges, and the dialogue with them was more along the lines of, ‘You want what? And you want it by when?’ There were an enormous number of enquiries, investigations and other requests for information. I also noticed a slowing in the migration of alternative strategies to registered products, particularly with ETFs (particularly) managed ETFs and leveraged ETFs.

In the second, investor ring, the dialogue was along the lines of: ‘Yes, there’s democracy, it’s tyranny of the majority, please return the proxy vote.’ Often, the process of dealing with funds that were gated or suspending liquidity was awkward and messy. The documents didn’t quite work or the investors didn’t understand the process that funds were trying to go through. More recently, investors have said ‘Let’s negotiate’. As the green shoots have sprung up, the process of launching a new hedge fund has become more like launching a private equity fund. We now go through multiple turns of the final private placement memorandum and partnership agreements as investors provide their commentary and often use independent legal counsel. In some instances, this has prolonged the launch process and made it much more expensive.

In the third ring are the accountants. Here the dialogue is: ‘You used to be my friend.’ Fin 48 and other issues have made the sort of collaborative process with accountants in the launching of hedge funds somewhat more adversarial or at least more complex, as there appear to be gaps between things that the lawyers can achieve and those things that accountants can sign off on, at least in advance. There have been operational difficulties, too, related to the treatment of positions that hedge funds are trying to take in real time, and the way accountants will view them at the time that the financial statements are prepared, including the way accountants will view the advice of legal counsel, and that’s been a bit difficult.

In my last ring, are hedge funds and their principals. I used to have one client. Very often, in the past 18 months, I’ve found myself with multiple clients as the principles of the hedge funds were going through these processes with investors. Very often, the principles disagreed with one another over governance, the way their fund documents worked and how they wanted to approach the situation. With that we’ll turn to emerging trends.

Keller: To put something into perspective, in very broad terms, hedge funds always come under scrutiny in every single market cycle for various reasons. On regulation, the public perception is basically always negative. But if you step back and look at an investment into a diversified hedge fund portfolio, ten years ago and the value of this today, vis-à-vis the risk asset cost that everyone feels comfortable with, equities, you get an enormous discrepancy. If you had put $100 in a diversified hedge fund portfolio on a pure index basis for ten years your hedge fund portfolio ends up with roughly $145 now. With the equity portfolio your initial $100 is now about $75. So, in terms of the value proposition of hedge funds and the compounding effect of avoiding large draw-downs, it’s a very powerful proposition. It’s not spectacular, it’s inherently boring, apart from a return perspective, it’s supposed to be. There’s a lot of talk of hedge funds letting investors down in 2007-08. But, in the long run, the industry has not let investors down.

Schmidtberger: I would say the performance issue was compounded by the governance issue, and perhaps over-simplification that there would always be absolute performance. The opaqueness of governance compounded investor concerns. We encountered this in fund of funds and in the feeder fund platforms. A great number of investors had a vague sense of what they were signed up for, but not really an understanding of the way in which these funds would operate under stress. And with good reason as there had not been particular stress for quite some time with these funds, but it did lead to a lot of confusion.

Byman: I’d challenge that. What is it that people should have known and didn’t? I still haven’t figured that out. I mean, fundamentally, in a way, it was a disaster. Markets cratered, liquidity in certain markets like convertible bond arbitrage, was non-existent. I would have rather seen the hedge fund industry be flat. I don’t know if that was realistic given that most hedge funds are directional. But, I don’t know, to this day, a) what was withheld, and b) what investors are told now that they weren’t told then. When I look at our client’s reportsto investors I don’t really see fundamental changes.

Barker: I completely agree. I think the one place that the hedge fund industry did not fail its investors was on performance. The biggest issue was a gross misalignment between assets and liabilities, from a liquidity perspective, across many parts of the industry. Even in highly liquid areas, we saw hedge fund businesses being challenged and in certain cases bringing down the gates where they weren’t justified. The biggest issue was in the period leading up to the crisis (only) the most aggressively questioning investors really had an understanding of the liquidity of the underlying book. That was a disservice to both the manager and the investor. If you can manage expectations effectively, then you have a better business. And I think this is one of the lessons that the industry has learned. Going back to the point I made earlier, it was the fact that hedge funds had been so successful, in delivering outstanding performance, over the very long-term, for their investors that they were able to develop that level of opacity that other parts of the financial services industry don’t have. The hedge fund industry was so focused on ensuring that it had capacity that it was desperate to maintain the right relationship with the underlying managers and would kowtow to the demands of the hedge fund. This relationship has changed, with regard to the funds of funds that survived, and the new ones that are coming up today. It is very much for the good of the industry.

Younghusband: There are various aspects of transparency. Valuation was one. A lot of investors were horrified when they discovered that the assets that they thought were in the fund were actually a great deal less. There was obviously a lot of disquiet that people were taking performance fees quarterly, on the basis of what, with the benefit of hindsight, turned out to be very inflated valuations. Transparency also impacts on governance. When it came down to it the directors were often fairly captive.

There was a huge back-tail created in terms of liquidity by the growth in the industry and the assumption that there would always be money coming in. There just wasn’t the money available to go out when you modelled portfolios based on historic subscriptions and redemptions. One of the biggest problems was that stuff that looked like it was in the documents for the end of the world, Dr Strangelove purposes, came to pass and it wasn’t just words anymore. Funds themselves struggled with what they were doing and how to do it. Often they got to the right place but the process of getting there was alarming. Also there were very clearly funds that suspended that should have been going into liquidation. A lack of clarity sometimes caused investor concerns.

Keller: I think one of the positive outcomes of the last few years is the massive increase in transparency across the industry. But ultimately this business will always be about investing into entrepreneurs. You can try to regulate and create transparent, regulated frameworks but at the end of the day, you’re investing into entrepreneurs and managing that process. It is about making a judgement call into the character of people.

Steinberger: Let’s turn to how lives have changed in terms of transparency and investor relations. For my part, there wasn’t any relationship with investors. Now we have a due diligence enquiry relating to one fund or another every day, and responding to those enquiries is now a part of my day-to-day existence. That might have been a once a quarter event two years ago.

Byman: I haven’t seen any change in transparency, basically. I think hedge funds were always relatively transparent. The relationship between investors and managers has always been a fairly balanced one. We monitor the due diligence requests we get from investors every week on both new investments the hedge fund investors have been making as well as investments in established managers. It’s up a bit, but isn’t material. People have always thought about checking with service providers, checking documentation, thinking hard about whether their investment is appropriate. Fundamentally, I don’t see a radical change. Just to put it in perspective, in Europe, where I have a better perspective, than globally, there are about 200 hedge funds that have over $75 million under management. For all but 15 of those hedge funds, it’s been business as usual. They didn’t gate or suspend and they haven’t changed their relationship with the investor. The other 15 are more complicated. Frankly, if I’d put money on 1st January 2009 with every one of those hedge funds which had gated or suspended I wouldn’t be here. I’d be clipping coupons on a beach somewhere because they were the best performers. In other words, most of the decisions to suspend or gate were the right ones, particularly in the convertible bond arbitrage space, where a lot of funds were up somewhere between 50% and 100%. So, fundamentally, I know it may not be an interesting answer, but I don’t see a radical change in that relationship.

Barker: The changes that we have seen in the level of transparency from managers, on both sides of the pond, both brand name and others, has been very significant and across the entire portfolio. Managers would tell you what exposures were, they would sometimes even break that up by liquidity, but there was never any real granularity about it. What managers now understand is, if they give you sector information, and maybe they give you asset class information, now it’s actually quite useful to give you both, in a matrix form, and the same with geographic exposures. So, I can understand that if I’ve got exposure to Germany, I’ve got it in financials and I’ve got it in credits, or equities. And so it’s the ability to go much more 3-D and really understand the make-up of the portfolio that I think has been a significant change. We have gone to a number of the managers, and defined the new reporting templates. And they’re very happy to take it on and they say actually, this makes sense. So, it wasn’t a lack of desire to meet the investor demands in the past, they just didn’t need to because they couldn’t be bothered. And I think that that is what has changed. But coming back to the point of the interface (between investor and manager) I see a little bit of a growing problem. And, again, it’s the first sign of a reversion to arrogance. A manager may well give investors the data through a data consolidator or supplier. But if you try and talk to a manger about it, he may say: ‘I can’t talk to you about it. It is down to ABC metrics. I couldn’t tell you how they’re interpreting the data we’re giving them.’ So, suddenly, the ability to communicate with the risk management team of the hedge fund, is reduced by the fact that there is this all-singing, all-dancing independently run transparency model sitting in the middle between investors and the manger. That’s a real concern to me.

Younghusband: With managed accounts investors want to reduce risk by having their own pocket. But an awful of them actually don’t have the facilities in-house to monitor that risk and I think there is a real need for those sort of risk consultants. The fact that they’re used for funds themselves is good for investors because it’s monitoring risk, but it also means that you lose the dialogue with the fund manager and that’s deeply worrying. What is also changing is that investors actually want to know what the parameters of a fund are and if the restrictions are real restrictions.

Steinberger: Let’s talk about managed accounts briefly.

Byman: A brief PB answer is that managed account activity since Lehman is up about 20%. If there’s one change, it’s that I don’t think we have a single client who won’t take a managed account at the right size. Everybody’s open to it.

Keller: The end investor demand for managed account based solutions has shot up dramatically over the last 12 months. There is a large proportion of public and corporate pension funds which are considering implementing their hedge fund allocations through a managed account platform either by buying an off-the-shelf, diversified, managed account-based solution, or by entering into an advisory relationship with one of the platform providers, self-directing, basically, and creating their own asset allocation and implementing, together with a partner, their hedge fund allocations, through to a platform.

Barker: There’s clearly a huge amount of complexity in implementing a managed account solution for many hedge fund strategies. It requires, if you want to do it on a diversified basis for your own platform, very, very deep pockets indeed.

We’ve found that we can achieve the same ends by creating fund of one structures rather than managed accounts, where we are the only investor in a fund, we sit on the board, and it is, to all intents and purposes, like a managed account, but, from the investor’s perspective, it’s a great deal more straightforward to put together. And, we don’t tend to see the same tracking error that is often the case with managed accounts.

Younghusband: So, why is there not so much tracking error?

Barker: Because they tend to have the same counter-party agreements across both funds.

Steinberger: Let’s switch over for just a moment to discuss some changes in prime brokerage.

Byman: The big change is the custodial vehicles that prime brokers are setting up. Morgan Stanley has one and our competitors are setting one up. The fundamental concept simplified is that to the extent the prime broker doesn’t need hedge fund manager’s assets, either for risk or for funding, they get swept into a separate custodial vehicle that should be bankruptcy remote. That’s a big change.

Younghusband: Have you seen multiple prime brokerages more than you have before?

Byman: It’s a complicated answer. Pre-Lehman we had a handful of religiously loyal clients who were sole prime broker with Morgan Stanley. That has almost completely disappeared. There is almost no one who has a sole prime broker. It’s also a fiduciary matter that you have to have two PBs. You have to be flexible enough to move your business, if you’re concerned about your prime broker, or to sweep everything into the custodial vehicle. It’s a practical matter – and this might sound counter-intuitive – but most of our clients have shrunk the number of PBs. The reason for that is with the industry shrinking you can’t feed everybody. So, the number has actually shrunk overall, but the days of sole prime broker are gone.

Steinberger: Let’s spend a bit of time on UCITS III.

The original European directive was in 1985 and was mainly for equities and gilts. In the early 2000s, things changed. The class of eligible assets was widened quite significantly, but they also allowed the use of derivatives, and the use of funds based on indices and ETFs. UCITS III is seen in Singapore, Hong Kong, Korea and Latin America, as being a safe product as there is independence between the manager and the custodian. There are also investment restrictions, which require a spread of risk and counter-party risk. For more complex funds you have to demonstrate to the regulator that’s authorising the fund that you do have a robust risk management processes. About 50% of the large hedge funds in the UK are launching UCITS vehicles, mostly either in Ireland or Luxembourg, because of the UK tax system.

The other thing is that the UCITS framework is designed for retail funds, but most of the UCITS funds that are launched by hedge fund managers are actually not aimed at the retail market. UCITS have to be available generally to anyone who wants to buy them, but they’re not actually marketed to everyone and the minimum restriction levels may put some people off. Also a number of hedge fund managers have been re-domiciling their funds from Cayman to Ireland as Qualifying Invested Funds. And some of those mangers will be launching parallel UCITS funds.

Barker: Do investors believe that regulators are necessarily the best people to define risk management structures? Is this potentially a dangerous trend in that it becomes due diligence by box ticking?

Younghusband: I think you’re absolutely right. There is a real danger, particularly for IFAs, that they can feel they’ve ticked the box because the regulator has passed it. It doesn’t mean to say you can’t lose all your money through bad investment.

Barker: I question any structure which forces the investor to utilise a derivative rather than the cash instrument. (UCITS) are adding complexity and counter-party risk to make the product safer. There are also question marks about the performance investors may get.

Keller: It goes to the heart of the challenge for hedge funds as an asset class. The world is just not willing to accept that hedge funds, somewhere belong into or between the private equity and the illiquid spectrum and fixed income and equities and the liquid side of their asset allocation. Trying to squeeze the asset class into a liquidity framework that doesn’t make natural sense is obviously questionable.

Question: Can the panel comment on how you reconcile fundamental institutionalisation and regulatory overlay with the basic entrepreneurial ability of the top 5% of managers in the hedge fund universe. Isn’t that conflict really at the heart of the future of this industry?

Steinberger: I’m not sure you can reconcile it. There are a number of tensions here. It’s an industry that’s getting more difficult to enter. You have an industry that has done very, very well for institutions, endowments, pension funds and universities that got into the alternatives space, years and years ago. Yet, retail investors have a hard time getting into this space and obtaining the same benefits. The best we can do is to have regulatory rationality and coherence across markets. Do your best to publicise it through disclosure, rather than arbitrarily setting up boxes to be ticked which we know brings up the law of unintended consequences. I’m not sure that there is an answer other than to raise the overall sophistication in the user market. Hopefully that brings others along.