Hedge Funds changing investment landscape

The Cayman Islands should expect significant continued growth

There are signs of shortages of prime capacity developing in the industry

Hedge funds have started a chain reaction that extends across the global fund management industry, and the Cayman Islands are well placed to take advantage of it, according to a study published by KPMG International and CREATE, the UK think tank.

The worldwide study presents the views of 550 top executives in 35 countries involved in hedge funds and their administration, prime broking, mainstream fund management and pension funds, with combined assets worth US$23 trillion.

While the recent unprecedented surge in demand for hedge funds by high-net-worth individuals will ease as performance deteriorates, the sheer weight of new money from pension funds will commoditise the industry.

This will likely drive down high charges and fees for managers, but administration fees should increase.

The KPMG-CREATE report finds that the Cayman Islands, which was at the forefront of the last wave of growth, will continue to remain at the forefront of the next wave as well.

As new entrants look to standardization and specialisation, the depth of service offerings for administration may reduce.

Anthony Cowell, Senior manager with KPMG’s Alternative Investments Practice in the Cayman Islands and Co-editor of the report, said the findings were extremely encouraging for Cayman.

‘As administration will become more concentrated in fewer centers, respondents surveyed listed the Cayman Islands in the top five countries likely to be the preferred location for administration over the next three years,’ he said.

‘However, it is evident that the hedge fund industry as a whole does not currently have the infrastructure to support the flood of money from institutional capital.

‘While it took 15 years to get to US$1 trillion, it may take only three to get to US$2 trillion,’ he said.

Administrators surveyed cited operational risks as a key limiting factor in the future.

The study noted the quality of the resulting capacity for growth in the industry, both for fund management and administration, is highly variable.

For hedge fund managers, the biggest risk is generating the high double digit returns that investors are led to expect.

At the administration end, the biggest risk is the mis-pricing of complex products.

As competition increases, the report also notes that the ongoing challenge for centres of administration like the Cayman Islands is how to retain a competitive edge.

Over time, as hedge fund strategies become more complex, the key differentiator amongst administrators will be the ability to scale the processes with new technology.

While most administration service offerings will rise in line with the worldwide growth of hedge funds, the report noted that it will be focused mainly at the complex end, involving independent valuation of investments.

Andy Stepaniuk, Partner with KPMG’s Alternative Investments Practice in the Cayman Islands, said: ‘Hedge funds and their top managers will outlast the bear market that gained them huge prominence. Their impact has forced mainstream fund managers to go back to their time honoured mission to provide absolute returns.’

The study predicts that the hedge funds industry will consolidate over the next three years because of under-utilised capacity, at the single and multi-manager, distribution and administration end.

For hedge fund managers, consolidation is likely to occur mainly via high attrition since they run life style businesses which are hard to sustain.

For managers of fund of hedge funds, in contrast, it should occur via mergers and acquisitions; and for administrators via acquisitions by global banks diversifying into prime broking and back office services.

The study concluded that the contours of the fund management industry will change by 2010.

If hedge funds are to retain their current uniqueness in the industry, their managers will constantly have to invent new ways of generating high returns.

Those who do not, may either pale into the emerging mosaic or become victims of the creative destruction which they sparked off in the first place.

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