Monthly Archives: June 2010

Positive 2010 Outlook for Investors and Hedge Funds

In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release). The report focuses on responses from 606 investors. 42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business. In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry. Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009. Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved. In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion. In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows. Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven. In fact, equity long/short makes up the largest portion of hedge fund assets. 51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets. Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets. Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010. While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities. Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back. The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year. In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst. This year, 45% of investors plan to invest in Asian (excluding Japan) funds–a significant jump from only 18% in 2009. Interest in investing in Chinese and Japanese funds is high compared with other countries. The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure. These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close. In contrast, investors anticipate the Western European region will not fare well–with 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Hedge Funds

Investors are increasingly investing in hedge funds. In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle. When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.” This benefit is particularly valuable in a volatile and uncertain market. “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds. The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence. On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing. The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use. They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely. In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion. Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations. Those investors who made over 10 initial allocations in 2009 were concentrated in Europe–a total of 54%. But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptions–the Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming. The investors that have made the most partial redemptions–30 or more in the last year, were primarily fund of funds and private banks. This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash. 50% of investors are either fully invested or only holding 0-5% cash. But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010. Those that predict they will be fully invested in the next six months increased from 18% to 21%. Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly. This year, “investments frozen with a manager” was a new category and also ranked very high. When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree. While those qualities continue to be important, investors have increasingly focused on risk management and transparency. This reflects greater caution and less reliance merely on manager pedigree. Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely. For most investors–over 50%, need 3-6 months to conduct due diligence of a manager. This statistic is consistent over the last three years. The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million. Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.” 17% of the investors surveyed seed managers. The majority of seeders are U.S. based–59%, with 30% in Europe, 9% in Asia, and 2% in Australia. Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform. Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees. Nearly half of seeders surveyed use this model. Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model. 19% of seeders surveyed adopt that model. Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share. Only 9% of seeders surveyed adopt the platform model. Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support. In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

Consultants

6% of the surveyed investors consider themselves to be investment consultants. The findings show that there has been an increasing presence of such consultants in the hedge fund industry. These firms serve as the “bridge between investment managers and pension funds.” The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence. These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

****

Audit Issues from Due Diligence Provider

Leave a reply

The following article is written by Chris Addy, president and CEO of Castle Hall Alternatives which is a hedge fund due diligence firm.

For funds raising assets from institutional investors, the due diligence process will be quite familiar and Chris describes some of the frustrations from the investor/due diligence standpoint. I would imagine that these issues will continue to arise as more service providers strive to find ways to limit their potential future liability. Please feel free to comment below.

****

A recap on some audit issues

Looking back over our posts over the past year or so, we’ve commented on a number of issues which impact investors’ due diligence procedures when thinking about the audit process, the financial statements, and the auditor themselves.

We thought it would be useful to recap on a group of issues which continue to be troubling:

1) And why can’t the auditor identify themselves?

Back in November, we commented on the challenge of getting the Big 4 audit firms to admit that they are, actually, the auditor of the fund in question. In the six months since then, practices appear to have standardized: typically, the Big 4 will now provide a form response, but only after the investor has signed an extensive disclaimer letter. The slight snag? The disclaimer is usually so wide ranging that it appears to materially impact the investors’ ability to sue the auditor in the event of audit failure (which, of course, is the idea). We advise our clients not to sign it.

As a counterpoint, it is worth noting – and forcefully reminding the Big 4 – that every other auditor on the planet makes the confirmation process smooth and effective. Castle Hall is particularly appreciative of the responsiveness and professionalism of Rothstein Kass each time we make an audit confirmation request. In fact, that reminds me…do I actually need a Big 4 auditor?

2) And it’s pretty much the same for SAS 70s..

Unfortunately, the SAS 70 process is pretty much the same – it is becoming increasingly difficult for the end investor to obtain a copy of the SAS 70 document for many administrators. This is, of course, despite the fact that the SAS 70 is now a key marketing point in the admin industry.

It’s particularly annoying when the SAS 70 is stated only to available (i) to the auditors of (ii) the administrator’s clients, the funds. The first point makes the SAS 70 process seem more than a little self serving, as the auditors give each other work for the sake of it. The second raises the broader issue (and one of our favorite topics) of who exactly is the administrator’s client – the fund or the investor?

A particular black mark goes to those administrators who will not provide investors with a copy of the SAS 70 under any circumstances, and insist on providing a summary of the SAS 70…prepared by themselves. And exactly how is the investor supposed to place any reliance on that?

An honorable mention in the hall of shame must go, however, to those administrators who try to charge the costs of their SAS 70 review through to their fund clients as an out of pocket expense. In other words, the admin expects the funds’ shareholders’ to pay for their own SAS 70.

And no, we still can’t see it.

3) Who distributes the financial statements?

While the confirmation issue above is tediously annoying, thinking practically, the risk that a hedge fund simply fabricates a relationship with PwC or KPMG is pretty remote. What is more likely is that a reputable audit firm has been appointed and completes their work…but a manager then elects to change some or all of the financial statements and gives investors a set of fake accounts. As we have said before, a copy of Adobe photoshop only costs $500.

The double irony is that, even with the audit confirmation we discussed above, the auditor does not send the investor the accounts directly. There is, therefore, no way of getting a direct confirmation from the auditor that the accounts in your possession are, in fact, genuine.

One suggestion we have heard would be, in the offshore world at least, for investors to access financial statements direct from the Cayman Monetary Authority (perhaps via a secure website with appropriate authorizations). This would draw on the requirement that the fund auditors must give the Cayman authority a copy of the (genuine) accounts themselves. An excellent idea….Cayman?

As a more immediate solution, we are always anxious to confirm that the fund administrator receives the audited financials direct from the auditor and thereafter sends them to investors. This is a great control – it ensures that the financial statements are authentic, and it also unequivocally confirms the identity of the auditor at the same time.

The snag? While this is crucially important, administrators seem pretty casual about the whole process. Admins are generally happy to do this, but only if a fund asks for this “service”, and many admins are certainly far from proactive on this topic. There are some admins, mind you, that don’t want to get involved (we came across one admin that had decided, on a related point, that they would not send offering memos to investors.)

In our mind, this is a vital control and should be mandatory for every administrator. Getting the financials from the admin is just as important as ensuring that the investor monthly NAV statements come from the admin and not from the manager.

4) And who is the audit report addressed to?

Another particular bugbear is the obsession of one of the Big 4 audit firms in Cayman to change the addressee of the audit report from “to the board of directors and shareholders” to just “to the board of directors”. The objective, of course, is transparent and predictable – the auditor is looking to enhance the concept of privity and assert that the firm only has a relationship with the Board and no relationship – none, never, nada – with the investor.

The irony here – the directors who are now the sole recipient of the audit are usually our rent a director friends who sit on a few hundred other hedge fund boards. And does anyone really think – including the partner at the Big 4 firm signing the opinion – that these guys really have time to read every set of audited financial statements from cover to cover?

One solution here – could the Cayman regulator mandate that the audit opinion must be addressed to the shareholders in order to be meet Cayman requirements? Again, this would be a small change that would send a very helpful, investor friendly signal from this jurisdiction.

5) In fact, do you even have to leave the office?

A final observation reflects what seems to be an emerging trend over the past audit cycle – certain auditors (and certain offices of certain auditors in particular) seem to be adopting a desk fieldwork process. We have recently completed due diligence on a number of funds – albeit usually long short equity – when both the administrator and the manager stated that the audit team had never came on site to do any audit work. All work was done remotely from the auditor’s own offices.

Now, aside from the fact that fieldwork is called fieldwork for a reason (er…you’re in the field) we see this as a worrying trend. It stands to question that the quality of the audit is not the same if you never look the individual responsible for preparing the accounts in the eye.

As a counterpoint to our observations, we do continue to recognize that the audit process is ever more challenging and that many skilled professionals work incredibly hard, especially during busy season. As just one example, we were recently speaking with the audit partner of a Big 4 firm discussing FIN 48 – a tortuous challenge for the profession.

At the same time, the audit process is critical for investors and we’re certainly entitled to ask tough questions – we are “sophisticated”, after all.

It’s also worth noting that the auditors’ ever increasing fees are, of course, borne by the end allocator. We’re happy to pay….provided we get good value. Net net, the hedge fund audit profession would certainly be well served to make things a little easier for the person cutting the pay cheque.

****

State Budget Shortfalls and Investment Adviser Registration

2 Replies

Financial Reform Bill May Devastate Overburdened State Securities Divisions

As many states are facing huge budget shortfalls, government services have been cutback and certain states have furloughed workers in certain divisions. In a number of states (including California) these budget cuts have affected the state securities divisions and accordingly the many state securities divisions are running dangerously lean. For example, I just recently talked with an examiner in the Oregon Division of Finance and Corporate Securities regarding a state blue sky filing for a hedge fund manager. The examiner told me that because of budget cuts and furlough days, the division will not even have a chance to review the blue sky filing we submit for five months! (Of course, they will cash the check immediately.)

This is obviously a huge issue and is only one instance of a state which does not currently have the resources to adequately perform oversight of the investment and securities activity which occur within its borders. In fact, many states currently don’t have the staff or expertise to adequately oversee the investment advisers and brokers registered with their securities division. While this is troubling, the problem is only going to get worse if the Financial Reform Bill proceeds as currently drafted.

While many have lauded the Senate bill, which will require hedge fund registration for managers with $100MM in AUM or more, an important issue has been overlooked. All investment advisers (in addition to hedge fund managers) with AUM of less than $100MM will be subject to state and not SEC registration. The $100MM threshold is an increase from the current threshold of $25MM. This means that a financial planner overseeing $90MM in assets (which was previously subject to SEC registration and periodic examination) will now be subject to regulation, generally, by the state in which that manager resides.

This means that if the financial reform bill goes through as currently drafted in the senate, the states are suddenly going to be responsible for overseeing a larger pool of managers. Even though the state will have increased responsibility, it is unlikely that state budgets will provide the securities divisions with more funding to properly oversee the new managers the divisions will be responsible for regulating. We find this troubling for investor protection reasons and for manager business continuity – that is, managers would be better off registered at the SEC level and subject to examination by SEC staff better trained (presumably) than state regulators.

We concede that the SEC has its own problems with funding and this provision allows them to focus on larger, more systemically important managers. However, we believe that states are going to be greatly burdened by the increase in jurisdictional oversight. Accordingly, we believe either Congress or the SEC provide a grandfathering provision which would allow current managers who exceed the $25MM threshold (but not the new $100MM threshold) to register or remain registered with the SEC.

****

Hedge Fund Events June 2010

Hedge Fund Law Blog

Hedge fund laws, starting a hedge fund, news and events…

Monthly Archives: June 2010

Positive 2010 Outlook for Investors and Hedge Funds

Audit Issues from Due Diligence Provider

State Budget Shortfalls and Investment Adviser Registration

Hedge Fund Events June 2010