New regulations and investor demands have put financial pressure on many new and smaller funds, which in turn squeeze the fees of service providers, delegates at the GAIM Ops conference on hedge fund due diligence heard last week. Meanwhile, funds of funds are losing ground as institutional investors increasingly invest directly into hedge funds. Although investors want more transparency, the funds available for due diligence work are often stagnating rather than growing with the increasing volume of work that needs to be done, panellists said.
The three-day GAIM Ops conference held at The Ritz Carlton, Grand Cayman from 23 to 25 April sketched the developments of the hedge fund industry in recent years and how these impact the evolving relationship between fund managers, service providers and investors.
Growth not better performance
The hedge fund industry has grown from $600 billion to $2 trillion during the past 10 years, but consultant Joel Press noted that while a larger industry means better infrastructure, it does not mean better performance. The high upfront costs required today by regulations and investor demands pose significant challenges for small start-up funds and generally mean that “smaller today is harder to do”, Mr. Press said.
The increasing costs of running a hedge fund effectively create a barrier of entry to the industry and make it harder for small funds to compete for and retain talent, he said.
Chairman of the Alternative Investment Management Association Todd Groome agreed, saying the days of setting up a hedge fund with $2 to $3 million may be over, because the infrastructure, reporting, legal and compliance requirements are simply too high.
For larger funds, in turn, succession planning will be a major issue going forward. The perception among investors that succession planning is negative will have to change as the industry matures, said Mr. Press.
Still the growth of the industry is a vote of confidence by investors, who value the ability of the industry to protect assets and manage risks in volatile markets, as well as the performance, said Mr. Groome, who highlighted three influential trends that are going to shape the hedge fund industry going forward.
First and foremost the investor structure in the hedge fund industry is changing. While 10 years ago, only 18 per cent of all funds allocated to hedge funds came from institutional investors, these large investors make up 61 per cent today. Institutionalisation is the most important trend and will have largest long-term effect, Mr. Groome said. More than 50 per cent of institutional investors want to increase their allocations to hedge funds, from an average 16.5 per cent to 19 per cent.
Another major trend is the change in the regulatory environment, which “has brought hedge funds under the regulatory tent”, Groome said, adopting the language used by the G20. But, he added, it also has increased the marginal costs for hedge funds and created barriers of entry.
The main focus in terms of regulation at the conference was the new manager registration with the SEC for managers managing more than $150 million, as well as on the reporting side, Form PF, which has to be completed by the manager. The depth of information that has to be provided depends on the size of the manager, and includes aggregated data and isolated data for the largest funds, investor profiles, leverage, exposures and a variety of risk assessments.
Meanwhile, the Alternative Investment Fund Managers Directive in the European Union has seen some push back. Panellists said the initial recommendations by the European Securities and Markets Authority for the regulations of the directive were rejected in some parts by the European Commission and raised new questions over the final look of the directive.
Yolanda McCoy, head of Investments and Securities at the Cayman Islands Monetary Authority, said the AIFM Directive is challenging for service providers and regulators alike. The directive demands that non-EU funds can only be marketed in the EU if the home regulator of the fund has a cooperation agreement with European regulators. The proposed wording of the memorandum of understanding constitutes a departure from typical regulator MoUs by making them binding, Ms. McCoy said, effectively meaning that CIMA would have to enforce EU regulations in Cayman for the funds that are marketed in the EU. At the moment, CIMA does not have the necessary sanctions mechanisms under Cayman Law.
A third trend, Mr. Groome said, is the convergence of traditional and alternative investment styles, either because hedge funds choose more traditional, long only investment strategies or because of traditional funds moving into the hedge fund space with short selling, mezzanine lending and other forms of credit, in response to investor demands.
How much transparency?
The tension between investor desire for more transparency and the amount of information can be reasonably provided by fund managers, also crystallised in the debate about whether Form PF should be made available to investors, even if this involves the use of non-disclosure agreements.
The volume of due diligence requests has grown for some time with more extensive questions being addressed to fund managers. But, as a panel on the “top 8 due diligence questions that are a waste of time” noted, this has also increased the time and cost pressures on funds, so much so that due diligence professionals now have to ask how much is too much?
The panel stated that there don’t need to be more questions, but more of the right questions. Efforts to standardise due diligence questionnaires, such as the fund director due diligence questionnaire prepared by AIMA, which is going to be released shortly, will help to some extent the panel said, but given the diversity of funds additional questions will still need to be tailored for each fund.
A panel debating the role of fund directors found that despite investors calling for more transparency and independent governance, investors have not properly articulated what exactly they want from the fund directors.