A New Environment for Hedge Funds

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1 A New Environment for Hedge Funds The eye of the storm may have passed, but the hedge fund industry still has a lot to think about as it rebuilds for the future. It was the financial equivalent of a force ten hurricane. In the second half of 2008, the hedge fund industry was battered on every front. As markets collapsed, underlying liquidity in key asset classes dried up and the demise of Lehman Brothers raised the spectre of major counterparty risk. As investors rushed for the exit, a significant minority of funds suspended redemptions or imposed gate restrictions, encouraging redemption requests at even the best performing and most liquid funds. Over the year as a whole, seven out of ten funds lost money. Total assets fell by up to a third between June and December 2008 and more than 350 funds shut down. And as if that were not enough, there was the Madoff scandal to contend with. Around 30 funds of hedge funds were directly exposed but the effect on investor confidence was widespread. Now some semblance of calm is returning, the industry is asking where it goes next. In the short term, says Neil Wilson, Editorial Director at HedgeFund Intelligence, shrinkage is likely to continue. About 20 per cent of the USD1.8 trillion in global hedge fund assets at the year-end is subject to gating restrictions indicating that the industry could contract by that amount before it hits bottom, he says. Reza Vishkai, Head of Alternatives at Insight Investment, says many smaller players will continue to drop out or merge with bigger providers. There are still 9,000 hedge funds. That is just not sustainable, he says.

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3 We may return to the situation of the 1990s when more than half the industry was made up of macro and managed futures funds. Neil Wilson HedgeFund Intelligence Money Waits on the Sidelines For all that, there is clear evidence of a lot of money on the sidelines that is just waiting to find its way into the hedge fund sector. Says Mr Wilson: A recent survey of investors with around USD1 trillion already invested in hedge funds, and a further USD290 billion in cash, showed that the majority expected to increase their holdings. That finding is borne out by the results of an institutional survey conducted late last year by SEI Knowledge Partnership in association with Greenwich Associates. Some 85 per cent of respondents said they were planning to either maintain or increase their target allocations to hedge funds. Where will the money go? Strategies such as managed futures, global macro and volatility arbitrage are all very liquid and have continued to do well, says Mr Wilson: With the experience of gating having served to remind investors of the importance of liquidity, these are likely to be the areas the money goes to first. We may return to the situation of the 1990s when more than half the industry was made up of macro and managed futures funds. This is despite the fact that there are bigger opportunities at the other end of the liquidity spectrum in distressed debt, for instance. Returns here have mostly been negative to date, but we won t see how profitable this will be for another two to three years, says Mr Wilson. Mr Vishkai agrees: There are a lot of opportunities for investors prepared to exploit recent market dislocations. But, they need to accept illiquidity risk and look at least two years out.

4 There are still 9,000 hedge funds. That is just not sustainable. Reza Vishkai Head of Alternatives at Insight Investments. Risk Perception has Shifted Investors perception of risk, however, has changed over the past year. The SEI/Greenwich survey reveals major concerns over portfolio transparency, operational quality and reporting. Following the events of 2008, says the study, Investors will have an intensified focus on operations, risk management and key noninvestment functions in addition to investment process. A reporting survey in November last year from the risk advisory consultancy, Edhec, drew similar conclusions. It finds that many hedge fund managers fail to understand how important a criterion information quality was in dictating their clients investment decisions. The largest gulf between funds and their investors was in the areas of liquidity risk, operational risk and portfolio composition, says the study. Mr Vishkai goes further. He says the typical hedge fund model needs rethinking: The unregulated nature of many funds, the issue of gates, the lack of transparency and proper communication it all needs changing. Towards a Regulated Environment Will Potts, Sales Director at Citi s Prime Finance, says with 90 per cent of the hedge fund assets still held offshore, there is a lot of pressure for change: Transparency and regulatory oversight are now important. With this in mind, a lot of funds will launch UCITS III vehicles or use structures such as Luxembourg s specialised investment vehicles (SIVs). There are onshore issues, too, he says: The lack of third-party administration and valuations in the US must be addressed. A number of firms have already taken the UCITS route. GLG Partners and Odey Asset Management both set up UCITS funds in the fourth quarter of 2008 and attracted big inflows. Brevan Howard followed in early The German asset manager, Aquila Capital, followed with what is thought to be the first managed futures UCITS fund. Insight Investment originally set up a range of absolute return funds under a Cayman umbrella in Two years later, they were replicated under UCITS III. Despite constraints on asset eligibility, Mr Vishkai says that, Using the so-called sophisticated approach, based on VaR budgets, there are few restrictions on what you can do within UCITS III. The comfort for investors is the requirement to have an independent custodian and administrator and fortnightly liquidity at the very least. The administrator must be able to generate complex OTC valuations, manage reconciliations with execution brokers and provide all the information required for risk reporting and collateral management. With its two hubs in Dublin and Luxembourg and fund administration operations spanning the globe, Citi is well positioned to provide all of that, says Marion Mulvey, Head of Alternative Investment Administration Services EMEA at Citi s Global Transaction Services. Take the example of a UK investor in a European fund. If Citi Dublin is chosen as administrator, we would pick up the trade files relating to the fund s dealings at the close of business each day, have the Boston office do the pricing and the Indian office the reconciliations. All of that will be happening while the investor sleeps. Dublin will then sign off on the NAV first thing the next morning, giving the investor the ability to react quickly with an upto-date price. Citi s Complex Pricing Group, located in Dublin, prices the more complex funds (see page 15). Performance fees are a common feature of many alternative investments or hedge funds. Normally these fees make up the largest part of the investment managers remuneration. With many funds below the high water mark on performance fees, there are increasing measures ensuring the fair treatment of all investors including new ones entering into the fund. Citi is experienced at applying different methods of performance fee calculation, says Nina Kleinbongartz, Vice President Alternative Fund Services for Luxembourg, Global Transaction Services, Citi, Depending on the investment manager s requirement we equal out exposure to performance fees through various equalisation calculation methodologies or multi-series accounting, which is automated via a fully integrated administration system.

5 The comfort for investors is the requirement to have an independent custodian and administrator and fortnightly liquidity at the very least. Dealing with Counterparty Risk The issue of counterparty risk, and particularly pooling and rehypothecation of hedge fund clients assets by prime brokers, remains a live one. Many clients of Lehman Brothers are still waiting to see a resolution to their claims for the return of assets. To deal with this issue, says Mr Potts, a number of the main prime broking firms are in the process of setting up special purpose vehicles into which funds unencumbered assets are periodically swept. Increasingly, the prime brokers clients want their assets held in bankruptcy-remote vehicles, he says. The rising popularity of UCITS III vehicles brings the role of prime broking into question, stresses Mr Vishkai. UCITS III does not lend itself to the prime broking model. It is custodian-based, he says. Even for offshore funds, the prime broker s role is increasingly diminishing as funds reduce their leverage and turn away from shorting. Some funds have been shifting their unencumbered assets to a thirdparty custodian. We believe the prime broking and custody worlds will combine and quickly, says Mr Potts: The holding and settling of assets will be brought together. Hedge funds will sign up with a prime broker and custodian. They will leave only assets pledged against loans or used as collateral for derivatives positions with their prime broker, putting the rest with a custodian. The key is to put a combined reporting mechanism in place covering all the assets. As one of the leading global custodians, and with its own inhouse prime broking operation, Citi is already leading the way in this area. In 2008, it was appointed administrator, custodian and prime broker for the in-house alpha organisation of the thirteenth largest European pension fund, Denmark s ATP. As part of the process, it built an enabling infrastructure for ATP Alpha which used external hedge fund managers to complement its in-house alpha business based on Citi s OpenPrime platform, giving investors the ability to access multiple prime brokers through the same front-end system. Through OpenPrime, ATP Alpha enjoys a reporting overlay that gives it an integrated picture of all its assets wherever they are held. In summary, the events of the past year have shifted a lot of investors priorities and lifted the bar on standards of regulation, transparency and risk management. While all the evidence suggests that institutional acceptance of the investment case for hedge funds remains as strong as ever, investors want the comfort of external administration, the protection that comes from ring-fencing assets and improved liquidity. As the SEI/Greenwich study concludes: the hedge funds succeeding in the years to come will be those that stand up to intensified due diligence by exhibiting institutional quality, providing more transparency and delivering consistent, non-correlated returns over time.

6 Bringing Certainty to Complex Pricing The valuation of complex Over-the- Counter (OTC) instruments is a hot topic. Investors are increasingly wary of pricing that relies on counterparties, while modelling can often be overly subjective and opaque in terms of market data and methodology. For funds keen to retain the confidence of investors, it is now vital to be able to demonstrate the transparency of investment pricing. Citi has long led the way in the provision of independent valuations for OTC derivatives and hard-to-price securities. Its Complex Pricing Group (CPG) constitutes a unique resource in the fund-accounting industry. Made up of people with finance, economics and mathematical backgrounds, the team can reverse-engineer any derivative by drilling down into the underlying structure. The CPG is located in Dublin but acts as a centralised, global utility. Responsible for pricing the more complex funds, it deals with over 20,000 OTC positions, providing valuations on a monthly, weekly or daily basis. It starts by sourcing prices from an everexpanding range of independent valuation providers. Those prices are then compared with secondary pricing sources. Where differences exceed predetermined tolerance levels, an analyst reviews the underlying market data and valuation model to determine the correct price. And that, says Hugh Hanna, Head of Global Data Services for Alternative Investment Administration Services at Citi s Global Transaction Services, is what sets CPG apart: If there is an disagreement about a price, very few accountants have the expertise to deep-dive and give an informed view. We do. In areas such as correlation swaps or equity variance swaps, we often have more data than the client has. We can analyse the volatility surface of the instrument, look at its sensitivity to moves in the underlying or even rework the assumptions in a client s model. Staying ahead of the game is vital. Within the CPG is an Analysis and Research unit that focuses on new instruments and models and keeps up with industry developments, says Mr Hanna. It liaises directly with clients, and particularly their traders. Where we find a new instrument type for which there is no independent valuation available, the unit will talk to valuation vendors to develop independent pricing. Mr Hanna says the events of recent months have made the CPG s work even more relevant than before. They have shown that mark-to-model valuations, constructed from the groundup, can be very different from counterparty marks, he says: Our ability to procure independent valuations, analyse and compare them and, if necessary, check models and decompose structures is a major value-add.

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