Regulation and the hedge fund industry
April 2013 | COVER STORY | INVESTMENT FUNDS
Financier Worldwide Magazine
In the current regulatory environment, hedge fund managers face an abundance of new challenges. Having recently come to terms with the US Dodd-Frank Act, many must now comply with the registration and disclosure requirements of the European AIFMD. To add to this, investors have stepped up their diligence when it comes to selection and redemption criteria, and are more likely to challenge management fees. As the cost of business rises, hedge funds are under pressure to achieve in an increasingly difficult environment.
The raft of regulation seen since 2008 has certainly forced investment managers to pause for thought, particularly with regard to operational and compliance functions. Chief concerns for fund managers include the complexity of operations resulting from additional regulatory burdens. “Investment managers have had to shore up these areas and ensure that these critical back-office functions are in a position to meet the evolving demands of the regulators,” explains Yehuda M. Braunstein, a partner at Sadis & Goldberg LLP. “Additionally, investors, especially institutional investors, have become more sophisticated and aware of the issues that managers must protect against, and are demanding that managers install measures where necessary. Performance in the industry has not suffered much as a result of regulation, although managers employing certain strategies, especially those involving significant leverage, have become more cautious as there is more transparency of their actions.” While, on the investor-side, regulation has brought positive change including increased transparency and oversight, both managers and investors have expressed concern over increased costs. Hedge funds have seen expenses rise as a result of increased investment in personnel and technology upgrades dedicated to reporting. Such additional expenses, some fear, create barriers to entry and could result in the consolidation of funds lacking the capital to support new infrastructure requirements.
Broadly, hedge fund managers have adjusted well to the new requirements. Outsourcing compliance work, hiring additional counsel, instituting new record-keeping policies and adapting marketing materials, are among the strategies employed to remain competitive and compliant. According to Preqin, however, performance remains a top issue for both investors and managers, and while it may not have suffered to date, both parties see it as a key issue for the year ahead. It is misleading to say, however, that the impact of regulation has been uniform across the industry, according to James Cripps, a partner at Slaughter & May. “The effect of increased regulation has, to a large extent, varied depending on the size of the management group, with the principal consequence significantly increased and increasing costs – both initial set-up and running – which smaller managers have less capacity to absorb and which also represent a rising barrier to new entrants. Indeed the major impact has been anti-competitive, with the market favouring the larger fund manager better able to cater for increasing fixed costs with, at the same time, little discernible benefit for investors, particularly any willing to rely on regulation rather than ongoing monitoring to protect their interests.”
The regulatory tidal wave has been global, causing concern for funds operating across jurisdictions. Europe recently took a large step toward clarifying what changes hedge funds can expect, with the publication of level 2 of the AIFMD in December 2012. The expectation is that the AIFMD, which is expected to be implemented by 22 July 2013, will lead to greater investor protection, avoid or minimise conflicts of interest, and improve on current supervision. In practical terms, AIFMD compliant managers will be able to market the funds they manage to European investors by means of a pan-European passport, which will facilitate access to capital of and investment by professional investors across Europe and lead to reduced costs.
Expense, however, is again a major concern among hedge fund managers, many of whom believe that complying with the rules could drive some smaller fund managers out of business or force them out of Europe where the rules are not applicable. In addition, critics say that rather than drawing secretive asset managers into the regulatory net, it will concentrate risk in fewer hands. “The impact of AIFMD is difficult to assess, although the major groups, in particular those with an existing family of UCITS funds, are better placed to absorb the consequent increase in running costs,” says Mr Cripps. “It seems likely that EU investors for non-EU funds will be increasingly restricted to existing institutional and pension fund investors, with only the larger non-EU managers actively seeking new investors from within the EU.”
Further challenges for the hedge fund industry will arise from the US Jumpstart our Business Startups (Jobs) Act, which proposes a loosening of the restrictions banning private-investment firms from advertising. A positive ruling by the SEC on lifting adverting restrictions could dramatically alter the way hedge funds market and attract new assets, however, most hedge funds are expected to tread lightly on implementation of the Act as they wait to see precisely what is and what isn’t allowed under the new framework.
In the new regulatory environment, compliance across multiple jurisdictions has become increasingly complex. And, while European-based managers have largely kept abreast of developments relating to the AIFMD, many US-based managers have not. It is critical, therefore, that managers fully appreciate all regulations before embarking on a fundraising campaign within a given jurisdiction, stresses Mr Braunstein. “There are a couple of practical points that will help managers: first, make sure that the employees in the compliance and legal functions are well-versed and trained on an ongoing basis in the applicable regulations; and second, the baseline compliance culture of an investment firm should be set to the standards of the jurisdiction with the most rigorous demands so that they are not scrambling to revamp their back office to comply in ways that they are unaccustomed to,” he says.
As seems to be the running theme, the challenge of compliance with both EU and the US regulation is primarily an issue of cost and complexity, although there are a number of areas where conflicts and unnecessary duplication remain. And, with much of the regulation affecting hedge funds yet to be finalised, uncertainty hangs over the future regulatory landscape.
Given the minefield that hedge fund managers now have to tread, they must be dedicated to ensuring compliance and adapting to regulatory change. On the whole, the industry has stepped up to the challenge, as managers accept that they will be scrutinised more heavily than in the past. With regulators displaying zero tolerance for ignorance or indifference, the risk to hedge funds of non-compliance is too great. Very few managers fail to treat compliance as vital.
The sheer volume of regulation has made compliance an ongoing issue and staying on top of the volume of change has been a major achievement for the industry. That said, there is more to be done. Although many hedge funds have already invested in improving compliance, others are still catching up. Compliance is now arguably as important as investment performance, given the reputational damage of an enforcement case.
Simply going through the motions of compliance is not enough. Investment managers must pay more attention to the idea of nurturing a culture within the firm. Many are now trying to make this their primary focus. “Most importantly, there must be a clear message from the top of the organisation that compliance is key,” says Mr Braunstein. “Also, it is very important that key employees from the various groups of a business are constantly in touch, create a working group, and map out a plan to ensure that the entire organisation is on the same page in terms of one cultural direction of the firm and compliance. Once that is done, it is critical for each person in the working group to know his or her role and be responsible for staying abreast of recent developments by attending seminars, workshops and brainstorming with counterparts in the industry.”
A further issue that the hedge fund industry grapples with is the amount it charges in management and performance fees. Traditional models have been under pressure since 2008 with many investors negotiating lower fee structures. However, according to Ernst & Young, investors and hedge fund managers have made little progress in reconciling their opinions on the matter since 2010 and, in a number of ways, continue to drift apart. The firm’s 2010 ‘Restoring the Balance’ report found that 94 percent of managers felt risk and performance were effectively aligned with the objectives of their investors. Only 50 percent of investors felt the same. Moving on two years, Ernst & Young’s 2012 survey found 87 percent of managers felt alignment was adequate, compared to only 42 percent of investors. In addition, more than two-thirds of managers reported that their compensation structure had not changed in the three previous years, with nearly 75 percent of their total compensation package paid in cash. Investors surveyed, by contrast, believe that less than 40 percent of total compensation should be paid in cash.
Many are of the view that given the performance of hedge funds compared with lower-cost investment vehicles, fee pressure will continue, which may lead to cost-cutting. Some believe hedge funds should adopt a fee structure similar to private equity funds. However, the issue of compensation is largely based on the size and reputation of a fund, which can impact the operation of smaller funds in their early infancy. Newer managers and start-ups have found that investors don’t have an appetite to pay the same management fees that they pay the more established managers. However, they often expect sound performance and the same level of risk controls. “While there is general pressure on fees, this appears to reflect principally concerns over performance and the absolute size of the fixed element of fees when NAVs are falling, as well as if the risk profile is inconsistent with fund performance both relative to benchmark and in absolute terms,” says Mr Cripps. “The key to alignment is to minimise manager profits when performance is negative or below benchmark – but this is obviously a trend that managers are keen to resist, for example by offering non-economic benefits such as portfolio data and analysis and increased briefing and contact.”
A number of other options are available to fund managers facing investor resistance, suggests Mr Braunstein, including offering reduced fees to investors investing at an initial closing (as a means to kick start a fund) and offering reduced fees based on investment size. Another option is to offer reduced fees for a certain period of time, with the understanding that if certain thresholds – for example, AUM or performance – are achieved, the fees may be increased.
In response to the new regulatory landscape, investment behaviour has undoubtably changed. However, this may reflect the impact of a changing regulatory environment for investors, rather than mangers, says Mr Cripps. “New regulatory solvency and similar requirements have seen some investors continuing to be risk averse, or even reducing allocations to alternative investments, while others have increased allocations because of a desire for yield and income that is not available from the more traditional classes. In general ‘due diligence’ – and its recording – has also increased with the investment process taking more time and becoming more document intrusive. It seems likely that investors will continue to be driven by performance, in particular the exploitation of market opportunities, while at the same time seeking greater transparency and timely portfolio data.” Further regulation, he adds, will likely lead to a growth in segregated account portfolios with bespoke terms for larger investors, and a demand for reduced fees reflecting reduced regulation.
In addition, regulation is not a factor driving evolving investment strategies. With the hedge fund industry maturing, competition is intensifying from traditional and non-traditional asset managers, and management companies looking for innovative ways to make profits have been introducing new vehicles to their range of funds. Recent entrants have accelerated industry convergence to a degree, in some cases blurring the distinction between hedge funds, private equity funds and mutual funds. Some funds have pursued new investment strategies involving other domestic or foreign-registered products such as Undertakings for Collective Investment in Transferable Securities (UCITS). Such diversification strategies can be expected to continue in 2013, according to Deloitte’s 2013 Hedge Fund Outlook “with some firms also expanding geographically… or into new asset classes such as European credit.”
Focus for 2013
The industry clearly faces challenges going forward, and the pressure is certainly not expected to abate in 2013. Managers must continue to balance regulatory strain with generating returns. Investing in appropriate infrastructure will be a major factor in shouldering the compliance burden along with the demands of investors. Larger funds, however, will be in a better position to handle the stresses of regulatory pressure, says Mr Braunstein. “In the coming months and years I would expect that the large, established funds will get larger as institutional investors have been biased towards continuing relationships that work and have been profitable. The larger managers will absorb some of the talent from the smaller managers who are having trouble competing. From a regulatory perspective, I would expect some fine tuning of the recent filing and disclosure rules.” Despite the obvious challenges, the hedge fund industry has succeeded in absorbing the blow of regulatory turmoil, and, in time, should emerge stronger and more structurally capable.
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