This is a follow up to our recent publication on Starting a Hedge Fund in 2015 and provides an overview of our thoughts on the start-up market in 2014 and themes for 2015 and beyond.
In terms of numbers, 2014 appears to be a relatively poor year for new hedge fund manager start-ups. According to initial industry data, the number of start-ups in 2014 globally fell 40 per cent compared to 2013 and the industry saw the lowest number of new start-ups since 2003. There were only around 40 new hedge fund manager start-ups in Europe1.
There were some new hedge fund manager start-ups of significant quality, many of which we at Dechert acted on. When it comes to managers with proven track records backed with significant seed capital the barriers to entry are rather smaller. It is the smaller and less well known managers who find it harder to launch.
We think that there are three key reasons for the 2014 slow down in start-ups. First, 2014 was a year of significant regulatory change both in the U.S. and Europe with the full or partial implementation of Dodd-Frank, FATCA, EMIR and, perhaps most significant, AIFMD. This led to increased uncertainty and higher costs. A manager who was happy to wait till the dust settled in 2015 would probably have been in a better position to launch. Second, the ease with which start-ups could raise critical assets has continued to be challenging (made worse by the fact that the amount of assets required for a viable launch has increased). Third, and more debatable, is that the regulatory change has acted as a further catalyst for what we shall call the ‘institutionalisation’ of hedge fund managers. In contrast, the 1990’s to the mid 2000’s can be seen as the era for start-ups. This labelling is not intended to undermine the importance of start-ups to the industry. Smaller and more entrepreneurial managers help encourage competition which can only be a good thing for investors. Further, there is a large pool of investors looking to seed start-ups so as to benefit from preferential fee rates and, often, to acquire equity and thus benefit from future growth. New start-ups will remain a significant feature of the industry albeit likely reduced in number.
The institutionalisation of hedge fund managers and growth in hedge fund AUM
Characteristics of an institutional hedge fund manager would be that it is not reliant on one or two star managers (and thus could survive the exit of a star manager), it has multiple products on offer to investors and has a brand name. It follows that such a manager will have a multi-year track record and assets under management in the US$ billions. Such fund managers tend to be well resourced with an experienced workforce providing the investment management teams with operational, accounting and legal support. They would also likely have a strong marketing team.
Such a hedge fund manager would likely appeal to institutional investors. Institutional investors are increasingly seeking exposure to alternatives but are keen to allocate to hedge fund managers they perceive to be of reputable standing in the industry with a significant investment in and focus on the operation of “checks and balances”. Investing in smaller or less well known managers is perceived as riskier either of itself or in terms of risk for the individual making the decision to invest if things go wrong. A trustee of a pension fund is less likely to be criticised if he makes a loss on an allocation to a large institutional hedge fund manager compared to if he made the same loss on an allocation to a smaller less well known manager. The same holds true for the consultants and the advisors to the trustees.
It is likely no coincidence that the rise of the institutional hedge fund manager coincides with a period where institutional investors are increasingly looking to allocate to alternative strategies.
A recent report on the hedge fund industry2 finds that a majority of managers expect that pension funds would be their primary source of capital by 2020. “The days of hedge funds simply being an investment tool for high net worth individuals are over” according to MFA President and CEO Richard H. Baker. “Institutional investors like pension plans, university endowments and charitable organisations now make up nearly 65 percent of the industry’s assets. These diverse partnerships help local economies and underscore the important role alternatives play at both the macro and micro levels.”
Despite the hyperbole regarding recent poor performance and high profile redemptions from hedge funds, total assets under management in the hedge fund industry reached record highs in 2014 and stood at around US$3 trillion in December 20143. The global hedge fund industry has grown by more than 10 percent a year since 2008 and industry data points to continued strong growth in hedge fund allocations (despite net assets decreasing in December and January). It seems that investors are increasingly convinced of the absolute return model and the need for a more diversified portfolio. Those who criticise recent hedge fund performance compared to recent stock market gains have misunderstood the absolute return model (namely that hedge fund returns should not be tied to indices). It also seems easily forgotten that between 30 December 1999 to 20 February 2015 the FTSE 100 had not appreciated4. Yet, according to some, active management is out of favour, the hedge fund model is broken and passive management is the way forward. Investors overall appear not to be convinced.
We think that the institutionalisation of hedge fund managers will continue and assets will increasingly be concentrated in a smaller number of managers offering a range of alternative products (managed by a number of star managers). This is a view shared by KPMG who note that “the increasingly rapid shift towards institutional investors, in particular, will catalyse significant changes in the way that managers structure, manage and market their products. The customization of fees and products – a trend already well underway – is just one strategy that managers are taking to attract institutional investors”.
Interestingly, a recent report by Credit Suisse5 found that over half of investors said that they were most likely to allocate to funds with between US$250 and $1 billion in assets under management in the next twelve months. This shows that, whilst investors prefer funds over a certain minimum size, they are not necessarily looking to allocate to the largest fund managers. Instead they seem keen to invest in funds that are not capacity constrained and maintain flexibility.
The future for hedge fund manager start-ups
Increased barriers to entry for new start-ups, primarily in terms of the difficulty in raising an initial critical mass of funds under management are likely to keep the number of new hedge managers at a lower level and will drive consolidation. Three-quarters of respondents to KPMG’s survey stated that they expect the number of hedge fund managers to either decrease or stay the same over the next five years. That is not a positive outcome for the hedge fund industry, its end users or the global markets. The argument for increased hedge fund regulation was to increase investor protection and reduce systemic risk. Yet the fact that regulatory change has made it harder to set-up (particularly in Europe) means that the regulation is indirectly encouraging fewer managers to hold more assets. That reduces investor choice, makes that money harder to manage and increases systemic risk. Increased regulation often increases the costs to investors of investing in hedge funds given that it is the funds which are likely to bear the increased costs. That institutional investors often prefer to wait until hedge fund managers have a track record adds to the problem. In the past, hedge fund managers would be able to launch with a smaller amount of capital (often their own supplemented with amounts from family and friends) and build a track record so as to attract true third party capital a couple of years later. The costs of starting a hedge fund makes this harder.
Some new hedge fund manager start-ups are now launching on fund platforms, many in or having an additional UCITS format. The growth in fund platforms has increased innovation with a variety of new fund platform products now on offer. Fund platforms can provide small hedge funds one or more of the following: seed capital, a regulatory umbrella (negating the need for the new manager to set up a regulated entity), operational support, office space and marketing services. Increasingly such platforms are providing new managers flexibility such that they can go it alone when they have a track record and sufficient assets under management. We can expect to see further growth and innovation in this area although it is not the right answer for all, or perhaps even the best long term answer for most. Quality legal advice to young managers here is critical to preserve their future flexibility.
Despite the barriers to entry, the start-up market remains important to the industry. A high concentration of assets in larger managers will likely impact upon performance as assets grow beyond the optimal level for the investment strategy being pursued. A high level of assets under management may also encourage managers to be more conservative so as to maintain a level of assets under management on which they will collect significant management fees. The industry benefits from the competition that smaller, innovative and hungry managers provide. Such managers now have three options: go it alone, join a platform or launch a new product with an existing manager. For the reasons already discussed, we expect that the percentage of managers going with the latter two options will increase.
Current themes for 2015 and beyond
In terms of current themes for the hedge fund start-up market, we think that the current regulatory restrictions in Europe will mean the U.S. and Asia will continue the 2014 theme of growing more strongly. Marketing in Europe is now harder for managers (both European and U.S.) managing non-European domiciled funds. Given that 76% per cent of institutional capital invested in hedge funds comes from outside Europe6 offshore funds such as Cayman Islands domiciled funds will continue to dominate. However, hedge fund managers seeking European money will increasingly need to launch European domiciled funds to access the market (a number of European investors, in particular pension funds, are not willing or unable to invest in Cayman funds). We are seeing a significant increase in U.S. managers interested in launching UCITS funds. The arrival of the ICAV in Dublin should also assist Ireland’s more meaningful entry into the global master feeder product market place. Interesting and inversely, a number of European managers appear to be looking to increase their access to U.S. capital by considering launching 40-Act funds.
Industry experts are expecting assets allocated to hedge fund strategies to increase in 2015. This is partly due to investors being attracted to the absolute return model and, connected to this, because after a period of rising equity markets and fixed income valuations, there is likely to be increased demand for funds with an emphasis on generating alpha (even if that involves greater volatility). As investors increasingly conclude that such equities and fixed income valuations are nearing their peak, hedge fund strategies might also be seen as an important hedge. Larger managers will continue to benefit the most from increased allocations.
Other continuing industry trends, which have already been widely commented on include increased downward pressure on management fees7 and an increasing number of hedge fund closures (for the same reasons affecting the start-up market). It will also be interesting to what extent traditional private equity and hedge fund managers continue to converge. We have recently seen multiple examples of debt fund strategies being launched by both private equity houses and hedge fund managers.