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The Future of Hedge Funds

Date: Monday, January 7, 2013
Author: Ahila Karan, ProHedge.co.uk

Entering the New Year, on the advice of Shane Brett, Author of ‘The Future of Hedge Funds’ and Founder of Global Perspectives consultancy, the objective should be to prepare for the inevitable operational demands of AIFMD. Released last month, Brett’s book dedicates an entire chapter to techniques required to manage change in a hedge fund. 

The AIFMD in itself, plays a major role in the future hedge fund framework. The operational costs affecting the industry, through increased reporting is “broadly similar to Form PF, but requires extra detail on exposures to investment types and liquidity in the portfolio”, which Brett explains is another operating cost to hedge funds. Costs, however, do not stop at in-house operations.

Previously hedge funds were not obliged to deal with depositaries, and currently the US doesn’t have to either. With the AIFMD, depositaries have become a pre-requisite to hedge fund activity. “To become a depositary you have to have deep pockets”, explains Brett, “with an existing custody network”. Ultimately it will be big institutions such as HSBC, Barclays who would fit the bill for this role.

The large liabilities facing depositaries under the Directive will force depositaries to demand a risk premia, through higher fees for services. Brett also discussed the possibility that this increased risk aversion may encourage depositaries to start regulating hedge funds. Depositaries may eventually become empowered to limit hedge fund manager activity; for example, a depositary may stop a manager from entering a certain asset market to circumvent expected losses. The allure of setting up a hedge fund grossly wanes, as the loss of power is a price to pay.

“Speaking to an industry adviser, he believed the minimum size of a hedge fund would be $300mn to survive, whereas 5 years ago, it would only have been $40[mn]… the sheer cost of due diligence and depositary payments amongst other operational regulatory costs” will  require higher seed capital to start up a hedge fund.

Brett expects the success of hedge funds to be defined by scale. “We’ll start seeing more mergers and larger hedge funds.” Medium sized funds will eventually drop out. In the current environment, BlackRock is the biggest hedge fund manager, but it is only 2% of the industry’s AUM, Brett explains, in the future “we’ll be seeing more consolidations, reducing market concentration.” As the scope for smaller funds diminishes, prospective managers will see less of an opening to start-up a new fund.

Regulatory enforcement

The severity of regulation has been discussed during the drafting process. The EU commission and ESMA have expressed separate recommendations leverage restrictions and calculations. The EU Commission sided with a more conservative measure compared to ESMA, who allowed for a less stringent leverage calculation. The finalised document from the EU commission adopts a simplified, ‘commitment method’, calculation, and states that leverage above 3 times the fund’s Net Asset Value (NAV) will trigger additional reporting requirements. “Regulation is necessary, but it has been more reactionary. Far more conservative.”

Do you agree that the gravity of regulation been fair? “Yes I do actually” Brett says, “5 years ago I would have been on the managers side. But now, after the crisis, my sympathies you could say are with the investor.”

He continues, however, “the means of carrying it out has been wrong – it’s become a case of inside EU or outside…but that’s ridiculous”. This discrepancy is unrealistic “with big international banks and wide spreading institutions.”

The fear of “regulation-wars” is ever more real if non-EEA managers are grossly affected. If the Passporting Scheme prevents “a hedge fund’s capacity to carry out profitable business…There’s scope in the future for that particular issue (regulatory wars) to evolve, which is not a healthy by-product of the AIFMD.”

Looking ahead, Brett believes managers should put together proper procedures. “Basically taking things that have been done by the best managers, and making the rest of the businesses in the industry catch up to the standard” is what funds should aim for. ‘The Future of Hedge Funds’ also discusses the need for hedge funds in the US to start preparing for the AIFMD, since this regulation impedes the entire industry and all European investment opportunities. Ultimately, preparation is key.