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2014 Hedge Funds Update: New regulations and shift to institutional money challenge smaller firms

Total worldwide assets for the hedge fund industry at the end of 2013 were $2.01 trillion, the highest level since June 2008 when global AUM peaked at $1.95 trillion1. The U.S. and UK continue to dominate, accounting for about 90% of all AUM. But other countries are making progress, notably Singapore, whose appearance in a recent Preqin Top 10 list signals a focus by the city-state on alternative investment vehicles2.

Asset Mgmt_plusIn a strong market for equities, however, relative performance for the industry as a whole fell behind: the HFRI Fund Weighted Composite Index, which covers a wide range of strategies, was up only 9.3% for the year, while the S&P 500 rose 32.2%3.

The lag is not surprising, given the approach of many hedge funds that makes them attractive to institutional investors. Hedge funds emphasize absolute return, offering reduced volatility over long time horizons but, as in the current environment, lower returns in a bull market4. Investment managers with still-fresh memories of the collapse of 2008 are happy to accept some of this tradeoff in their overall portfolio strategy. At the same time, more hedge funds are attracting money through long-only strategies that appeal to investors dissatisfied with returns from active equity and bond investment managers5.

The winning strategies for the industry in 2013 focused on mortgage-backed securities6 and distressed securities7 (i.e., the bonds of companies that are in trouble). However, the success stories for 2014 won’t be those of 2013 — especially if interest rates are on the rise. Fund managers will be under pressure to outstrip last year’s performance; if they fail to deliver, continued pressure on fees from institutional investors will be the likely result. 

 
“Reducing fees can positively affect an emerging manager's ability to raise capital. One of my clients, whose fund launched in October 2012 with $35 million, reduced management fees to 1.25% and incentive fees to 12.5% for certain new investors. They closed out the year with over $300 million in AUM.” 
-- Michael Patanella, Asset Management Sector Leader

Shift to institutions puts pressure on smaller funds 

In the past few years, the hedge fund industry has become increasingly reliant on institutional investors, compared with the high net worth individuals that had dominated the industry before the financial crisis. Institutions have specific needs for hedge funds in terms of transparency, infrastructure, scale (i.e., ability to absorb funds inflows) and compliance. These requirements may not trump investment performance, but they can nonetheless be decisive. The smaller players also face significant margin pressure. Management fees, long pegged at 2% of AUM, have fallen to the 1% to 1.75% range — with startups hungry for investors accepting less. Traditional performance fees of 20% of returns have declined to 18% on average, and hurdle rates — levels of return that must be exceeded before the performance fees kick in — are increasingly common8. At the same time, fixed costs have significantly increased because of the regulatory burdens imposed by the Dodd-Frank Act and other legislation.

In order to contend with these expenses, smaller hedge funds have had to grow their AUM. According to a November 2013 survey by Citi, hedge fund managers need “at least $300 million to cover their management company costs without additional capital or incentive fee payouts”9. “Reducing fees can positively affect an emerging manager’s ability to raise capital,” comments Patanella. “One of my clients, whose fund launched in October 2012 with $35 million, reduced management fees to 1.25% and incentive fees to 12.5% for certain new investors. At the same time, they posted gains of 25% in June 2013 and 32% by year end. They closed out the year with over $300 million in AUM. The question now is whether they will keep the reduced fee structure or go back to what is considered a ‘normal fee structure.’” 

Positive trends 

But there are reasons for optimism as well. A recovering economy and loftier stock prices have the potential to boost the number of high net worth individuals (HNWIs): up 14.1% in 2012, compared with a much smaller increase of 3.9% in 2011. Research and Markets estimates the number of U.S. HNWIs will grow 42.3% to about 9.8 million in 2017; their wealth is expected to increase 83% to $39.6 trillion10. These numbers augur well for smaller funds seeking to revive this traditional source of funding11

Two developments have the potential to expand the universe of potential hedge fund customers to less-wealthy retail investors: The widening of hedge fund product lines to include alternative mutual funds (which offer constant risk-adjusted returns of 5-7%) and the lifting of the ban on advertising. Although few funds are currently planning to take advantage of the new marketing guidance, many more are adopting a wait-and-see attitude12. Even if a flood of hedge fund ads isn’t imminent, the new rule should have an impact on, for example, the content on company websites and, longer term, how smaller funds attract new investors. But funds need to recognize that claims of superior investment performance invite SEC interest; firms should be prepared for additional regulatory scrutiny if they make such assertions in their marketing literature. 

ON THE HORIZON: THE REGULATORY IMPACT IN 2014

The spate of new rules in the wake of the financial crisis and further guidance issued by both U.S. and EU authorities in 2013 will have a major impact on operations for hedge funds. 

Bad actor 

The SEC has amended Rule 506 to prohibit a hedge fund from making an offering because of certain “bad actors” who have a “disqualifying event” for events occurring after Sept. 23, 2013. Disqualifying events include criminal convictions, court orders, final orders and other orders in connection with violations of securities laws. 

AbacusValuation 

The Alternative Investment Fund Managers Directive (AIFMD) of the EU went into effect in July 2013. Among its provisions is a rule that requires hedge funds to have written policies and procedures that make clear the valuation methodologies used and how the valuation (i.e., the roles of various parties) was decided. The AIFMD has limited impact on North American hedge funds, affecting primarily those that market in Europe. Nevertheless, coupled with the existing strong focus of the SEC on fair value measurement of Level 3 securities, the new rules reflect the trend toward greater oversight of the valuation of hedge fund assets. 

Custody 

The SEC issued new guidance in August 2013 that will allow investment advisers to safeguard certain certificated, privately offered securities themselves, rather than pay financial institutions to hold them. The move is expected to reduce costs for private equity and hedge funds.

Investment company definition 

The FASB issued Accounting Standards Update (ASU) No. 2013-08, which changes the method for determining whether an entity is an investment company.

Liquidation basis of accounting 

An ASU issued by the FASB will reduce the diversity in accounting treatment for liquidating hedge funds.Mustard-business-woman

FATCA 
The IRS issued final regulations at the start of last year for the Foreign Account Tax Compliance Act (FATCA), an effort to reduce noncompliance by U.S. taxpayers with foreign accounts. The rules have wide application throughout the asset management industry, including private equity and hedge funds. Already the implementation date for FATCA has been delayed until July 1, 2014; it could be extended still further.

Swaps 
In late December, the Commodity Futures Trading Commission (CFTC) extended some swap rules to firms in overseas jurisdictions. Offshore hedge funds that engage in swap transactions exceeding $8 billion may be designated as a U.S. person, which would subject them to mandatory reporting, record-keeping and clearing requirements. 

The Volcker rule 
The end of 2013 saw the introduction of the Volcker rule, which restricts banks’ so-called proprietary trading; their ownership interests in private equity and hedge funds; and their sponsorship of these funds. Under the rule, investments in private equity or hedge funds are capped at 3% of the Tier I (core) capital of the bank; the bank also can’t account for more than 3% of such funds’ investments. Some analysts also believe that, while the rule will reduce capital sources for alternative funds, the restrictions it places on banks reduce competition and create more opportunities for non-banking institutions14. The rule is set to go into effect April 1, 2014, with full compliance required by July 21, 2015.

Read the full report (PDF).


1 See Eureka Hedge Indicies.
2 2013 Preqin Global Hedge Fund Report, p. 7.
3 Williamson, Christine. "Hedge fund returns top 9% in 2013 — 2 reports," Pensions & Investments, Jan. 8, 2014.
4 Shari, Michael. “Hedge Funds Assets Grow, Returns Don’t,” Barron’s, Oct. 18, 2013.
5 “Funds-of-Funds Managers Going Long Only,” Pensions and Investments, Dec. 23, 2013.
6 See Farrell, Maureen, "Hedge funds win big with subprime mortgages," CNN Money, Jan. 4, 2013.
7 Delevingne, Lawrence, “Stocks weren’t the best hedge fund strategy in 2013,” CNBC, Dec. 20, 2013.
8 Zuckerman, Gregory; Chung, Juliet; Corkery, Michael. “Hedge Funds Cut Back on Fees,” The Wall Street Journal, Sept. 9, 2013.

9 Citi Prime Finance 2013 Business Expense Benchmark Survey, November 2013. 
10 Research and Markets: “High Net Worth Trends in the U.S. 2013." 
11 Emerging managers face a unique set of challenges in raising the profile of their funds and attracting funding. As part of Grant Thornton’s commitment to serving emerging managers, in March 2014, we will sponsor the second annual Emerging Managers Awards, an event aimed at increasing the exposure of emerging fund managers to institutional investors. Find out more by visiting http://emergingmanagerawards.com.
12 Aksia’s 2014 Hedge Fund Manager Survey.
13 Scott, Jeremy. “Will FATCA Ever Go Into Effect?,” Forbes, Dec. 12, 2012.
14 Hoopes, Stephen. “Volcker Rule and the Financial Sector,” IBISWorld, Dec. 20, 2013.