Hedge Fund Outlook 2013, Part 2 of 2

Date: Friday, December 21, 2012
Author: Parin Shah, ProHedge.co.uk

In the second of a two-part series, PROHEDGE speaks to Phillip Chapple, Executive Director of KB Associates in the UK about the outlook for the hedge fund industry in 2013. Click here if you missed part one.

Phillip has over 15 years experience in the financial services industry and has held previous positions that include those of CFO/COO of Ironshield Capital Management and COO of IBIS Asset Management. Phillip has also spent a number of years in prime brokerage at Merrill Lynch where he was responsible for supporting funds across a diverse range of strategies.

Going into 2013, what’s your opinion on the outlook for funds in general?

I’m optimistic mainly because I’ve seen different types of investors coming out of their shell. The big concern is that we haven’t had a “blow up” for a little while now, which we are cautious about as this would be a setback. There is a situation of quiet optimism and more money flowing that I’ve seen in the last 3-4 years, going to more locations than was the case. I would we’re never going to see the days like before when money was wired on a whim and situations where investors say “you’re a bit like them, so here is some money”. The investors are not the same people.

What impact is the Eurozone crisis having on where funds might choose to place themselves?

The main problem is that we still don’t have certainty which would enable people to know which way to go. At the moment we’re seeing 2 streams. The vast majority are still going Cayman because the view is it’s the cheapest and easiest option. We are seeing a growing minority who go direct to an onshore location on the feeling that they will be “AIFM-proof”. The only concern is if you go that way, you’ve got a tighter deadline for compliance.

Is volatility aversion among investors something that might change if the global macro picture improves?

The reason for volatility aversion is the mandate of investors. What attracts them to hedge funds is the core “hedged” feature which can offer protection. With Long-Only, you are very exposed to the volatility of the market. Through hedge funds, investors can negate some risks; it’s kind of what hedge funds were built for in reality.

Do you see the Long-Only manager dying out to some extent?

There will always be a place for those guys. But I do see allocations to alternatives growing year on year by pension funds.

Will there still be pressure on the management fees being charged?

For the small and start-up most are still “2-and-20”. The “2” is because investors like to see the manager able to afford infrastructure. When you’re heading towards $1bn, that’s when investors begin to question the “2” because the incentive is then to build assets. On the performance fee, we see a lot of hurdles out there now and are starting to see some clawbacks. We are seeing ways of keeping alignment between managers and investors. “2-and-20” might not be what day 1 investors pay, as discounts may be given to get people over the line.

What developments do you see in terms of hedge fund boards becoming more transparent and accountable to investors?

Most of the investors I talk to want a fully independent board, with some talking of a majority independent board. Full independence would mean that the manager does not sit on the board. Some service providers and investors will say that having managers on the board means they are there to respond to the board. Others will say that they can have this function without being on the board, as a board seat would leave them conflicted on many decisions. There is a lot of demand for independence, the right expertise in the right jurisdiction, with directors who are not sitting on too many boards. It’s actually quite hard to find enough people to sit on boards. Where you get some conflict at the moment is surrounding the minutes from board meetings; a lot of board directors will argue that it is not a good thing to distribute this information as confidential matters relating to the board will then not be able to be discussed properly. The argument is then over whether redacted minutes are sufficient. There is in general a real push toward responsibility.

With the start-ups that you see, are they implementing board independence from day 1?

Ideally yes. The big problem on the other side is paying for these individuals. To get the guys that most investors want is more expensive in comparison to the guys who you might have opted for historically. It’s all about getting the balance. It’s something the fund spends its money on because it’s investors’ money that is paying for fulfilling and investor demand. This has to be within reason because if you’re spending $50,000 on directors a year and you’ve only got $20m in the fund, it becomes a problem. It’s an area of focus because if you get unsuitable people who fail to understand their role or are on too many boards it becomes a due diligence issue.

From your experience in the industry so far, what are the key lessons that you have learnt?

Never cut corners. Always read the detail. Always take a third party perspective to anything you’re doing. For a manager, I would always say try and understand what an external investor would think about what you’re doing. Detail is important because it is often the small things that can frustrate people more than the bigger things. The number of documents we see where one word completely changed the intent or the control, you don’t want your investors picking that up.

The industry is subject to a lot of regulatory pressure and is consequently undergoing big changes. Do you feel that transitioning into the hedge fund industry from financial services industry is now more difficult?

The hedge fund industry is still very entrepreneurial. My main advice to people would be to know what your strengths are and where to go for your weaknesses. The reality is that no-one can know everything. The hedge fund industry doesn’t inherently have a lot of control points; for example if you’re the COO of a small firm, there is no-one to pick up where you’ve made mistakes until the point where it’s a real problem. The people who screw up are the ones who don’t question themselves or their own understanding enough. If you really understand it and know it, fine, but if you don’t, it would be a mistake to presume you understand. That is the most dangerous thing. I’ve seen situations before where people will go to a provider, use mnemonics and be dangerous enough without really understanding. For me, to thrive in this industry, you’ve always got to ask questions.