The hedge fund industry is going through a process of change and maturity according to a recent survey conducted by Kinetic Partners, the professional services firm dedicated solely to the investment management industry.

The survey, aimed at London based hedge fund managers, addressed a range of operational and market related topics including the market's response to some elements of the FSA's discussion paper "Hedge funds: A discussion of risk and regulatory engagement". Survey participants comprised of leading London based hedge fund managers, including most of the top 20 who alone represent around $100 billion of funds under management.

It is generally recognised that hedge funds are indeed playing an increasingly important and beneficial role in financial markets. However, many pertinent issues were also uncovered in the survey which spells the onset of great structural changes in the industry. The need to improve operational risk controls, corporate governance, and access to talent were acknowledged. Improved returns, a need to strengthen infrastructure and a move towards the institutionalisation of funds were also identified as key issues facing the industry.

Key concerns

Hedge funds in their most simple guise offer great benefits. They present greater diversification options for investors and also allow conservative and first time investors access to the alternative markets through their fund of funds products. However, some risks are more obvious and acute in hedge funds compared to many other asset classes. This is due to the industry's characteristics of reduced maturity, higher leverage, rapid growth, lack of loyalty of investors and the challenges in building middle and back office support functions. Today some key concerns stand out from the rest and these have been divulged by some of the industry's most influential players in Kinetic Partners' Hedge Fund Survey.

Fund of funds accounted for over 50% of the investor base in hedge funds in the majorityof cases. They were popular because they provided easier access to the market for the less experienced investor. The short term investment horizon and occasional lack of loyalty were seen as issues for many managers.

Within the survey Kinetic Partners examined the most effective hedge fund marketing tools for investors and institutions. Manager performance and market reputation were seen to be the most significant tools in marketing to investors, while in marketing to institutions, manager performance and the perceived strength of the control environment/risk management were seen to be the most significant tools. Somewhat surprisingly perhaps, the quality of reporting was found to be of lesser importance in both cases, ostensibly because most respondents felt that they had mature reporting processes, but also because their existing investors were content with the quality of output. There was no real sense amongst managers that transparency would increase and become an important marketing tool.

Returns and Infrastructure

Infrastructure and process issues are almost as great a concern as performance, according to the respondents. Hedge fund managers identified improved risk adjusted returns, strengthening the back office and IT infrastructure, as well as diversification of product offering, as the most important issues to them. Respondents generally agreed that the cost of IT infrastructure and outsourced operations, which are principally fund administration and accounting, was reasonable. However, mostrespondents also felt that the service levels could improve, as service level agreements were not actively monitored. From an IT perspective, most respondents had implemented a disaster recovery plan, but surprisingly few had actually tested it. When questioned on issues for the industry as a whole, hedge fund managers stated it was crucial to demonstrate consistent returns and so reduce the erosion rate amongst investors, particularly amongst fund of fund investors.

Talent

The main constraint on growing the hedge fund industry was identified as lack of access to talent, in both execution and support functions. This lack of talent seemed to be driven by the limited supply of appropriate fund managers willing to change jobs, and the affordability of these managers. Investors' perception of sector performance and their appetite for risk were also seen as potential inhibitors to growth in the industry, although improved returns would go some way to mitigating these. Other perceived constraints to growth included access to capital, competition for assets from competitor markets (e.g. private equity and long only houses), and to a much lesser extent, increased regulation.

US fee structures

US and European fee structures were raised in the survey. The majority of respondents believed the aggressive fee structures charged in the US may be seen in Europe at some point, and unsurprisingly investors are expected to resist this upward fee pressure. To some extent these structures are already here, with no high water marks on some funds, but the extremes of fee structures including those with much higher management and performance fees, are likely to be limited in their use. Most respondents indicated that they would gauge their potential investors' appetite and willingness to pay high fees before drafting a prospectus.

Controls and operational risk issues

Given the risk based nature of the industry, operating with suitable and tested control and operational risk tools is of the utmost importance for any hedge fund manager. Evidence from the survey suggests that many start up hedge fund managers do not have all the resources and practices in place, or the appropriate company management experience, to enable this. This would suggest a need for managers to embrace operational risk control procedures and implement these in their daily functions. The survey results particularly saw the need for better organised and resourced middle office functions.

Independent valuation is critical to investor confidence and the integrity of the market. The FSA has only recently highlighted the need for administrators and hedge fund managers to undertake complete and sufficient asset valuations. Survey respondents believed that the lack of independent valuation for complex assets posed a growing risk to the industry. Respondents felt both a lack of product specific skill within administrators in the hedge fund field, as well as a lack of independent valuation for complex assets, posed a potential risk to 53the industry, but not one that is unique to the hedge fund sector or necessarily pervasive.

Need for improved corporate governance

The issue of regulation has always been a concern to the industry, however respondents agreed there was now a place for regulation and believed that the industry has a duty to improve and demonstrate enhanced corporate governance and risk management procedures. The FSA noted only recently in their discussion paper DP 054 that they were not keen to over regulate the hedge fund sector. In compliance with the FSA's requirement to maintain "appropriate systems and controls", all those surveyed had undertaken to adequately document all internal controls, policies and procedures and had appointed an individual responsible for monitoring the control environment. Traditionally this role would have been carried out by the Chief Operations Officer, however many respondents have created a distinct role for a Chief Risk Officer.

Changinglandscape

The typical investor base for hedge funds is evolving, with institutional and pension fund exposure to hedge funds growing over time. The survey results are first hand proof of this and show evidence of a structural change within the industry. A path towards larger and more institutionalised funds was predicted by the majority of the respondents, with a smaller group believing this path would lead to consolidation of smaller funds through acquisition and merger. This polarisation effect sees the big getting bigger. If this polarisation trend were to continue, those remaining as small and start up hedge funds may see harder times ahead.

In addition, there was a general consensus that to be commercially viable, the fund size needed to be in excess of US$50m, which is significantly higher than historically felt.

However, there was no consistent view that the current attrition rate amongst the smaller managers might increase. Issues such as different cultures, the ability to merge and handle different strategies and platforms were all seen as restricting the potential for merger and acquisition. The continued entry of new managers with low levels of funds under management seems assured, reflecting the current statistics of 5% of funds under management being in the hands of less than 90% of hedge fund managers.
 

Institutional investors and fund of hedge funds have become more important as sources of capital in recent years. Survey results confirmed this shift, with almost 80% of the respondents' investor base currently being made up of funds of hedge funds and institutional capital. Reinforcing the institutionalisation stance already identified, respondents also found that the investor profile over the next two years is likely to move towards an increased proportion of institutions, with 48% of respondents predicting this move, as shown in the diagram above. However some respondents felt that institutional entrants to the market would also come via the fund of funds route.

Differentiation from competitors

Over half of respondents found that differentiation from competitors is becoming increasingly difficult due to increased numbers of competitors in the market place. This influx of competitors has meant that returns in long/short strategies have subsequently become more normalised across the market. Quality control, risk management and corporate governance were seen as major factors in distinguishing one manager from another, with quality of personnel also seen as a key differentiator.

Summary

The survey has revealed some fascinating trends and insights. Leading hedge fund managers are comfortable with their risk management programmes and corporate governance, but recognise more could be done. The key issue for them is finding talent, developing and testing their infrastructure programmes, and dealing with issues directly affecting their funds, such as administrator quality, valuation issues and the polarisation effect that increased institutional presence is now bringing. These results provide valuable insights into how the hedge fund environment is reacting and realigning itself to today's dynamic marketplace, and given the fact that the UK already manages 75% of European hedge funds, these results cannot be taken lightly.

The hedge fund industry will continue to mature and contribute positively to the financial market. Investors are of course looking for the best return possible but consistent, stable returns based on strong infrastructure are their main objective. Hedge fund managers are thus taking very seriously the need to improve their infrastructure.

Kinetic Partners is a global professional services boutique providing a range of assurance, advisory and consulting services exclusively to theinvestment management industry. Established as a joint venture with Chiltern plc in March 2005, the firm is part of Moores Rowland International (MRI), a worldwide association of independent accountancy, tax and business advisory practices.