Hedge funds in Asia
September 2012 | TALKINGPOINT | LITIGATION & DISPUTE RESOLUTION
FW moderates a discussion on hedge funds in Asia between Scott Peterman, a partner at Sidley Austin LLP, and Rod Palmer, Global Head of Investment Funds at Walkers Global.
FW: Could you outline some of the key trends you have witnessed in the Asia hedge funds market over the last year or so? In broad terms, how would you describe the recent performance of Asia focused hedge funds?
Peterman: According to Eurekahedge, hedge funds were down for the fourth consecutive month in June, though total AUM had increased marginally. Other reports suggest the contrary, though, stating that allocations to Asian hedge funds decreased markedly during Q2. Eurekahedge also reported that Japanese managers recorded the highest returns among regional mandates while relative value and fixed income strategies outperformed peers in June. We have confirmed among our own client base that hedge funds with substantial exposure to Japanese equities had performed well in relative terms. On the other hand, Japan-focused hedge funds had a net loss in Q2, owing to the performance of the Nikkei. Stock-picking acumen was rewarded while broad exposure to the market was punished. In other markets, interest in China has not been as strong as it was, due to poor performance across the board of the Chinese markets, and perhaps due to political instability in advance of imminent changes in the government. Korea has also not performed well. Of the Asia-focused hedge funds, more of them are now opening offices in Asia, perhaps due to slow growth in their home markets, and a realisation that having a local footprint yields benefits in excess of the costs.
Palmer: So far this year we have seen an increase in assets under management for Asian hedge funds, despite the small dip in the overall number of funds operating in Asia amid some closures. Activity for new fund launches has remained reasonably robust this year, with around 30 to 40 new fund launches in Asia during the first half of 2012, raising some $2bn in aggregate AUM. The typical new fund is closing with an average launch size between $50m and $100m, with multi-strategy comprising the bulk of the funds we are launching in Hong Kong and Singapore, followed by Asian equities. One of the key trends in Asia over the past year or so has been the influx of a number of large global hedge fund players and other high profile launches in Hong Kong. Examples include Brevan Howard’s alliance with CICC Asset Management, Myriad, PCA, Oasis and Azentus to name but a few. By comparison, some of the smaller hedge funds in Asia are finding it tough going, resulting in some wind downs. The main reasons cited are the difficult capital raising conditions and a 'flight to quality' on the part of existing investors, as well as high barriers to entry and poor performance returns in difficult trading conditions. Returns from Asia funds excluding Japan have produced flat to low single digit returns so far this year. Japan proved to be one of the better performing markets in Asia in early 2012 and, as a result, we have seen a recent uptick in new hedge funds for Japanese fund managers.
FW: To what extent have persistent economic troubles in the euro zone and other developed regions helped to increase interest in Asian investments?
Peterman: The continuing reversals and shifts in risk sentiment have made it a difficult investing environment. The ever-shifting economic and political landscape has reinforced the ongoing interest from offshore institutional and private investors for hedge funds that are perceived as relatively stable, core investments opportunities. To the extent investors perceive growth opportunities in Asia, they are interested in investing with fund managers that have demonstrated ability to dampen the higher volatility that characterises many of the markets in Asia.
Palmer: Investor risk aversion levels remain high as a result of the issues in the Eurozone. The associated increase in market volatility, combined with the decline in the global growth outlook is leading to caution on the part of hedge fund investors in Asian markets.
FW: Is there a strong appetite from investors for participation in this asset class? Are global pension funds, for example, actively seeking exposure to Asian investments via hedge funds?
Palmer: In general, hedge funds as an alternative investment continue to find favour with large global pension funds in terms of the percentage of their portfolios allocated to the asset class. If we drill down further on the allocations, there has been a clear focus on investing with the larger institutional hedge fund managers at the expense of the smaller start-up funds and fund of funds. In terms of the global institutional investor’s current view of investing in hedge fund strategies focused on Asian equities, recent broad based surveys of global pension funds have indicated that they were reducing their allocations to such strategies, but this position is temporal and in response to point in time investment views and a heightened risk aversion, rather than any fundamental shift away from Asian hedge funds. Any decrease in market volatility and investor risk aversion will likely lead to greater capital flows into Asian hedge funds as institutional allocators seek to re-balance their portfolios.
Peterman: Global pension funds are seeking exposure to Asian investments via hedge funds, though their efforts are frequently frustrated because there are few institutional quality hedge fund managers operating in Asia. Size is also a significant constraint since many pension funds cannot be more than X percent of a fund’s AUM, and there are perhaps but 20 to 25 Asian-based hedge funds with AUM greater than $1bn.
FW: Have there been any recent regularly developments that will impact the hedge funds industry in Asia going forward?
Palmer: Early signs that China is beginning to open its doors to capital raising for hedge funds point to one of the most significant regulatory developments for some time in the region, amid the introduction of the QDLP scheme and an expansion of the QFII quota in an attempt to boost investment into the fund industry. One of the main new initiatives currently taking place in China is the Qualified Domestic Limited Partner programme (QDLP), which is a pilot scheme to be launched by the Shanghai municipal government’s financial services office. The programme will permit qualifying foreign hedge funds to establish subsidiaries in China to raise renminbi-denominated investment in their vehicles through private placements which must be invested in foreign markets. Currently there are no private placement rules for foreign hedge funds in mainland China, so the QDLP could be good news for hedge funds wanting to tap a market that had previously been off-limits. Details of the scheme are sketchy however, and there appears to be some confusion over the size limit for funds participating in the pilot. Some say it will be limited to hedge fund managers with assets under management of $500m or more, while others give much higher figures. Reports indicate that capital that can be raised under the scheme will be limited to $5bn overall but this may be expanded to $60bn by 2017, although the levels are yet to be confirmed. Other initiatives taking place in China include the Wenzhou Pilot, which will allow residents of the city to invest funds overseas, while recent changes to the existing Qualified Foreign Institutional Investor (QFII) quotas could also benefit the fund industry. Elsewhere in Asia, changes to the regulatory regime for hedge fund managers in Singapore have attracted some attention, with the Monetary Authority of Singapore (MAS) setting a deadline for the official release of the new rules for fund managers for August 2012. All fund management companies in Singapore will be required to meet the enhanced competency, business conduct, and capital requirements by that time. Those with assets under management greater than SGD250m will have to be licensed, while those below this threshold may operate under the ‘Registered Fund Management Company’ regime, which will replace the existing ‘Exempt Fund Manager’ regime. Fund managers therefore will need to liaise with the MAS regarding their new status and must implement enhanced compliance controls and processes accordingly.
Peterman: Aside from the requirement, if applicable, to register as an investment adviser under the US Investment Advisers Act of 1940, the key regulatory development has been the requirement under the Dodd Frank Act to register as a commodity pool operator (CPO). A CPO is essentially a sponsor or promoter of a commodity pool – that is, a fund that trades any futures, futures options and now non-securities based swaps and FX contracts. The US Commodity Trading Futures Commission (CFTC) takes the view it has jurisdiction over a non-US CPO of any pool sold to US persons. In the past, most non-US CPOs relied on an exemption from registration with the CFTC under Rule 4.13(a)(4), which was a sophisticated investor exemption. However, the CFTC has eliminated this exemption. Many hedge fund managers who seek to avoid registration with the CFTC will either have to cease trading ‘commodity interests’ or not accept US investors in their hedge funds. Absent an available exemption from registration, such as that available under Rule 4.13(a)(3), in 2013 CPOs that trade in futures, futures options and, now, non-securities based swaps and FX contracts.
FW: Have you seen an emphasis placed on any particular fund types and structures in the current market?
Peterman: For years, the typical Asian-based hedge fund offered its securities via a stand-alone, single entity fund, usually, a Cayman Islands exempted company. A number of Asian-based hedge fund managers have been exploring other options for structuring their funds that will afford tax efficient access to the US and European capital markets. They are doing this either by establishing a new fund, or by restructuring an existing offshore fund to incorporate a master-feeder structure, or partial master-feeder structure. A master-feeder fund structure is commonly used to accumulate funds raised from both US taxable, US tax-exempt and non-US investors into one central vehicle – the master fund – to enhance the critical mass of tradable assets, improve the economies of scale under which the fund arrangements operate and enhance operational efficiencies, thereby reducing costs. Master-feeder fund structures have long been used by US-based hedge fund managers for their funds as a means of implementing a tax effective structure for both US taxable and non-US or US tax-exempt investors. In Asia, the use of master-feeder fund structures is not as widespread. However, there has been an increased interest among Asian-based hedge fund managers in sourcing investors from the US, and a correspondingly increased interest in establishing master-feeder fund structures or restructuring existing hedge funds, through which US taxable investors may invest in a tax efficient manner. The increased interest in structuring funds in this manner is due to a realisation that, first, the US is the source of 50 percent of global hedge fund AUM, and second, break-even for an Asian-based hedge fund is approximately S$100m. Industry statistics suggest that of the more than 1100 Asian-based hedge funds, more than 80 percent do not have AUM of $100m, and thus are in danger of not surviving. Of the strategies that we see most commonly deployed, most—perhaps three-quarters – are long/short equity hedge strategies. There are a lot of ‘me, too’ strategies, which make it difficult for fund managers to differentiate themselves. The ‘safety in numbers’ approach does not work, and more fund managers will have to think about implementing customised or highly differentiated investment strategies. That will be difficult.
Palmer: The Cayman Islands remains by far the dominant jurisdiction for the domicile of hedge funds in Asia. As for the legal structure of the fund vehicle, this remains a Cayman corporate for almost all the offshore hedge funds that Walkers has established, with the exception being the use of Cayman unit trust vehicles for hedge funds being marketed in Japan. For smaller hedge fund start-ups , with low initial closing assets under management, we are seeing an emphasis on setting up cost efficient legal structures for the purposes of building a track record with the initial seed money. These fund vehicles can then be restructured prior to going to market to raise third party capital in order to meet the institutional expectations regarding regulation oversight, corporate governance and risk management.
FW: What key issues arise when fund managers and investors negotiate fund terms, management fees, and so on? What about liquidity control, redemptions and clawbacks?
Peterman: The key trends and terms that we see fund managers and investors negotiating in terms of fees and expense items include: performance compensation taken over multi-year period; performance compensation only for ‘skill-based’ performance in excess of ‘alpha’; performance compensation clawbacks; limits on fees on SPVs or after suspension; and performance fees on realised gains only, with offset for unrealised losses. In addition, we see greater acceptance of contribution-by-contribution performance compensation calculations on the domestic — non-US — side; fee discounts negotiated across multiple manager funds; performance compensation on illiquid assets paid in-kind; discounted management fees for less liquidity; and withdrawal fees payable to the manager, not the fund, in the case of soft lock-ups. In terms of liquidity, among many other things, we are seeing simpler and investor friendly liquidity terms becoming more common; fewer and shorter soft lock-up periods, and no hard locks, though hard locks are still more common in Asia; individual gates rather than fund level gates, which, again, are more common in Asia; and individual gates triggered by overall redemption levels. As one might expect, the key issue implicated by these investor demands and manager deliverables is having sufficient staff that can support the objectives of an institutional investor class. Increasingly, it has become apparent that investing in hedge funds as a strategy is more aligned and more appropriate for institutional investors, than say, high net worth investors or even many family offices, who are seeking high, risk-adjusted returns. The investment objectives across these three groups are not identical.
Palmer: Early stage investors still expect the usual fee discount discussion, which is typically only offered to one or two anchor investors. These fee discounts are generally geared towards putting such investors in a position similar – on an economic basis – to if they had taken a revenue/equity stake in the investment manager, along the lines of the typical seeding deal. More recently, some traditional seeders are foregoing an investment in the investment manager and the attendant liability issues, perceived or otherwise, in return for steeper fee discounts. As the issue of transparency grows in prominence, we are seeing an increased level of transparency being offered to all investors, rather than just a select few, with information rights being set out in the PPM rather than in side letters. Performance fee periods are in most cases annual, with not much in the way of clawback but frequently high watermarks come into play. Other trends we have observed include management fees becoming a greater reflection of the investment manager’s actual budgeted operating expenses, with less downward pressure on performance fees. Fees are also being traded against liquidity, so that those investors accepting less liquidity are paying lower fees. Liquidity is also being tailored more closely to the liquidity of the underlying portfolio makeup.
FW: Would you say that Asian hedge fund managers are more focused on risk management and internal governance issues than they were in past years? If so, what practical steps have they taken to address these issues?
Palmer: While risk management and governance issues have become an increasing focus for Asia-based hedge fund managers, this is not taking place at the same pace to the same extent that we are seeing in the US and UK markets. The changes that we are seeing in Asia, to a large degree, have been driven by institutional investors out of the US and UK and reflect their increased negotiating power as a result of the more difficult capital raising conditions. Several high profile frauds by hedge fund managers and to a lesser extent, recent case law developments such as the Weavering case, have also driven these changes. Among the key practical steps being taken to address governance issues are an increased number of investment managers hiring third party risk management companies in order to monitor the risks, while there has also been a notable shift toward independent boards of directors on Asian hedge funds. In many cases, investment managers are going further than simply hiring more independent directors but are also employing a mix of director service providers that are providing the independent directors to the boards.
Peterman: In a word, yes. In terms of governance, institutional investors are demanding – and getting – more high quality, independent directors; voting shares sold to investors that desire them; precision in drafting fund investment mandates; and investment restrictions. Investors are also getting consistency across master-feeder structures; director authority to replace manager and service providers; director approval of valuations and financial statements reasonable limitation on number of directorships per director; and board meetings, at least quarterly. In terms of risk monitoring and reporting, some of the steps that more institutionally-focused hedge funds are implementing, due to investor demand, include: risk reports distributed to investors monthly; non-preferential risk reporting to investors; objective pre-determined risk limits; stress testing; and independent risk monitoring.
Scott D. Peterman is a partner in Sidley Austin’s Hong Kong office, advising on corporate and commercial transactions with a primary focus on hedge fund formation, private equity transactions, and alternative investments. He is one of the world’s leading legal authorities on Japanese hedge funds, and one of only a handful of practicing attorneys in the world who holds a designation as a Chartered Financial Analyst (CFA), issued by the CFA Institute. He is endorsed by Chambers Asia Pacific, IFLR 1000 and PLC’s Which Lawyer for his practice in Investment Funds in Hong Kong. Mr Peterman can be contacted on +852 2509 7819 or by email: email@example.com.
Rod Palmer is the head of Global Investment Funds Group at Walkers and has extensive experience advising in investment funds of all types, including private equity funds and hedge funds. He also advises on general corporate matters including IPOs, the sale and purchase of shares and assets, joint ventures and corporate reorganisations including statutory mergers, schemes of arrangement and takeovers. Mr Palmer can be contacted on +852 2596 3339 or by email: firstname.lastname@example.org.
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