Hedge Funds - Trends & Liabilities

01 March 2006

Stephen Ross and Andy Knox, Man Investments

Over the past 12 months, some industry commentators have noted convergence trends, in particular in the corporate space where certain longer lock-up hedge fund strategies vie with private equity debt and equity vehicles for investment opportunities.

The focus of this introductory piece is on hedge funds, hedge funds of funds and related structured products. This recognises that, although there is some blurring around the edges, the look and feel of, for example, a typical European private equity buyout fund, remains very different from the systematic trading of a managed futures programme, or the quant-driven analysis that underpins many approaches within the relative value style of hedge fund investing.

The industry therefore merits its own commentary, distinct from the other component pieces of the private funds mix.

Aggregate Growth

Over the past 12 months, hedge funds have continued to receive sustained capital inflows, with aggregate hedge fund assets under management estimated to be in excess of US$1.2 trillion at the end of March 2006, following a strong first quarter. One recent industry survey forecasted assets under management growth rates of US$2 trillion by 2009, US$4 trillion by 2013 and US$6 trillion by 2015.

Although the hedge fund industry still accounts for around 2.2 per cent of global equity and fixed income assets, owing to leverage and generally more activist trading styles, hedge funds nonetheless account for a significant portion of trading volumes of some assets, according to industry reports.

The risk in speaking about hedge funds in generic terms is to fail to distinguish between very different investment approaches, and these aggregate figures will necessarily under- or overestimate the asset flows to or from particular strategies. The bottom line, however, remains that investors are continuing to see sustained opportunities in this asset class as a whole.

Product Development In a Maturing Industry

As with any successful and maturing industry, the number of product manufacturers is on the increase. Single hedge fund managers are offering multi-strategy products; traditional asset managers are moving to an absolute return approach and to alternative investments; investment banks are increasingly using hedge fund underlyings in structured product offerings or within indices and large institutions; and private banks are establishing their own fund of hedge fund businesses.

In product terms, performance and track record remain key. This is particularly the case in the private investor sector, which is generally more sensitive to short-term changes in performance and where the benchmarks are not so much other hedge funds as the broad investable universe, in particular domestic stock markets, deposit interest rates and local property markets.

If performance and track record are broadly comparable, then in a more competitive market place investment firms will have to distinguish themselves through service, quality and variety, for example through more focused investment strategies, best of class and activist approaches, more diversified pay-offs and reporting, including transparency to manager level and value at risk data.

At the same time, the investor base is broadening with evidence that greater institutional appetite, in particular among pension fund investors, is posing new structuring and reporting challenges.

Taken together, these factors are extending the depth and quality of existing product ranges, and also driving considerable research and development efforts, both inhouse and with external advisers.

Convergence

Convergence between private equity and some hedge fund styles remains a much discussed item in the trade press. As noted above, some of the reported activity could be viewed as merely the more public manifestations of strategies that fall within established hedge fund styles (essentially event or activist driven). In these, hedge fund managers have always taken positions in trades for longer than the perceived hedge fund norm and there has always been, to a degree, an overlap with the private equity skill base, such as capital restructures and workouts. Arguably, these strategies have been brought to the fore more recently by a combination of factors, including lower returns in some of the more liquid strategies and the imposition of longer lock-ups facilitating this type of trading.

Not surprisingly, where there is a communality of skill sets and experience, there has been some movement of teams between firms. Some structural biases such as high watermark performance fees versus carried interest and, in relation to the transactions themselves, no hurdle, no transaction fee sharing and no restrictions on hostiles generally give hedge funds the advantage in recruitment.

Where there is an identity of strategy and lock-up profile, manufacturing products designed to deliver these strategies to investors look comparatively straightforward. It is much harder to see a solution because liquidity and valuation disparities, for hybrids that seek to marry the more liquid hedge fund strategies with the standard five-year investment cycle of mainstream LBO funds beyond hedge funds as a cash management solution to the performance drag of the private equity commitments or drawdown model.

Building Workable Regulatory Frameworks

In the face of the increasing popularity of hedge funds, a number of jurisdictions have introduced domestic frameworks to allow regulated hedge funds or funds of hedge funds to be developed and sold in their markets. The challenge for regulators has been to put regimes in place that satisfy public policy-generated transparency and investment policy requirements, as well as the infrastructure needed to deliver it, without stifling the ability of hedge funds to generate attractive returns or imposing excessively burdensome requirements on top of the existing reporting regimes and risk systems that these funds typically have in place.

In practice, although the mid- to longterm prospects look attractive, the short-term barriers to entry have seen offshore assets continuing to overshadow onshore assets in volume terms, and product producers are continuing to exploit unregulated channels to deliver products to market.

To a certain extent, the same challenges have been apparent in North America, where some managers have imposed a minimum two-year hard lock-up with the effect of possibly taking advantage of an exemption to not register with the US Securities and Exchange Commission (SEC) and not engage with the full scope of the regulatory framework the SEC has proposed. Similarly, managers focusing on illiquid strategies in an effort to capture ‘true alpha’ are also attempting to not register with the SEC by taking advantage of the two year lock-up exemption.

Macro legislative changes are having an indirect, but no less significant, effect on the industry and are also demonstrating the challenges faced by policy makers in accommodating hedge funds and hedge fund related activity.

For example, some commentators observe in the prospective Basel II changes to the manner in which banks are regulated that hedge funds, as a significant subset of alternatives generally, have not been easily accommodated within a system that is fundamentally oriented towards traditional bonds and equities. Unfavourable regulatory capital treatment of hedge fund investments or related activities could have significant implications for banks that actively participate in the hedge fund industry through prime brokerage, leverage and proprietary investments.

Growth Markets

Industry statistics suggest that the fastest growing area for the hedge fund industry is the Asia Pacific region with assets under management for this region growing nearly 35 per cent in 2005, although it should be noted that the most significant shares of the global market remain in North America and Europe.

Some commentators point to a level of volatility in these developing markets historically, but long-term players with established offices in, or coverage of, this region should be well placed to benefit.

Japan in particular looks attractive, with a recent report suggesting appetite among local institutions to invest in hedge funds as part of a recalibration of portfolios that are heavily dependent on equities and bonds, is twice the level of their US counterparts and five times the level of their British peers.

In Europe, although aggregate growth rates appear slower, there have been a considerable number of initiatives in individual countries to facilitate the manufacture and distribution of hedge funds and more are in the pipeline. Product manufacturers will continue to review the opportunities presented by new legislation, balancing the attractions of access to new channels against the costs of developing products within the new frameworks, and with the bottom-line concern of being able to achieve attractive returns relative to other investment opportunities within those channels.

Implications for Legal Service Providers

Servicing this industry will continue to offer law firms market exposure to a growth business across a range of disciplines.

The multi-disciplinary requirements of the industry pose challenges to those firms which continue to organise themselves along traditional silo lines with disconnected capital markets, derivatives and funds practices, but offer opportunities for those firms who can demonstrate genuinely integrated capabilities.

A Sample of These Opportunities:

• Advising on the significant legal challenges inherent in adapting new products to fledgling onshorisation regimes, and also on the related regulatory issues which underpin this area and product development and distribution generally. Merger and acquisition work where existing industry participants consolidate within the sector or across sectors (eg, a hedge fund buys a long-only manager or a private equity firm bolts on hedge fund capability).

• Product development work, such as rationalising or refining existing platforms, as well as developing new products.

• Advising banks on the regulatory capital implications of their engagement with hedge funds.

• Documenting back- and middle-office outsourcing transactions where service levels and costs suggest that an external service provider is the preferred solution.

It is worth noting that, together with private equity and real estate funds, a significant number of sizeable transactions, including for example, hedge fund activity in relation to the public markets, are controlled or influenced by alternative investment vehicles. Firms that are not aware of the nature or structure of alternative investment vehicles are therefore not plugged in to some of the key drivers of economic activity across the globe. In addition, following on from the above comments regarding growth markets, legal service providers that are based in the Asia-Pacific region and developing markets such as India or China, or with an established presence, will be well placed to assist product manufacturers in exploiting local opportunities.

Man Investments’ Approach to Hiring Counsel

Generally, Man Investments takes a core satellite approach to hiring counsel, using a combination of existing ‘satellite’ niche relationships for offshore work and in certain regions with a ‘core’ global relationship with a single provider which can deliver in-depth integrated international expertise in the areas of capital markets, derivatives, fund work, regulatory, securities and tax. In all cases the key is delivery on the legal fundamentals, but client service, pricing and an active approach to product innovation and opening up new markets are also important features in these relationships.

Conclusion

The signs of an asset class approaching maturity and the legal issues this presents are readily apparent in many of the current trends noted above and the industry will continue to look to the foremost international legal practitioners set out in publications such as this to play their part in taking the industry to the next level.

It is not possible to buy entry into Who's Who Legal

terms and conditionscontact us