Hedge Funds

Author: | Published: 3 Oct 1999
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Hedge Funds: The Times Are A Changin'

If you haven't noticed, the hedge fund world is changing dramatically. The evolution has just begun. The small industry of boutiques once known for its intellect, yet privacy and independence is in the midst of a major refurbishment. It may be the best chance in a long while to get a closer look.

The original premise of hedge funds — to provide maximum flexibility and latitude to the management of investment portfolios — was overwhelmingly compelling. The early years of hedge funds and even some recent years had been fueled by a supply side vision with a powerful but anonymous cheering section of high net worth private individuals and selected institutional investors. In a global economy furthered by the internet, the premise for hedge funds is even more compelling as mutual funds struggle with commodity characterization as price competition and saturation challenge that investment sector. At the same time, hedge funds are reaching out for that same investor looking to maintain its return profile but with the risk management comforts to which it has grown accustomed. What is emerging is a redesigned hedge fund organization.

It is a popular thesis that hedge funds were changed as the result of the market events of 1998, including most noticeably the troubles of Long-Term Capital Management. But the forces that were changing the asset management world were well under way as early as 1997. The hedge fund industry was not only looking to retain its investor base (as was suggested by the LTCM debacle) but to reach out for new investors. Why did the focus change?

We suggested earlier that hedge funds at one point became largely supply side driven. That is, the economics associated with the hedge fund industry — ie 1-2% of assets under management and 20% of profits — were so compelling that it was illogical for truly talented traders, research analysts and portfolio managers to work under a subjective bonus arrangement. Additionally, the technology developed by prime brokers, software providers and administrators had developed to a degree that barriers to entry were eliminated. Finally, the tax advantages of working in a pass-through tax characteristic and fee deferral environment cemented the decision. All of this also allowed geographical mobility — so, if you could attract sufficient capital (most could on reputation alone), you could do the math fairly easily. This ironically came at the time the financial services world was consolidating. While major organizations struggled to piece together their strategy, much of the trading talent was leaving to join the hedge fund world. The hedge fund world was in harmony

But we have seen that change often takes place in a nonlinear fashion. So too was the case with the financial services sector. It could not afford to lose either its talent or its clients. It could either set up its own hedge funds, set up hedge funds for the elite talent, invest in hedge funds, invest in the economics of hedge funds or redefine the landscape. What occurred was a combination of all of these strategies.

The financial institutions were faced with a dilemma. As these changes were taking place, the wealth that had been accumulated over the last 10 years from the bull market had in many ways transformed the traditional clients of many of these firms to affluence levels demanding a more sophisticated product. Many of these clients were focused on asset allocation strategies and searching for investments not specifically correlated with benchmarks but those that would provide absolute returns. — specifically, hedge funds. Simultaneously, KYC studies confirmed that many of these clients were also the most profitable for the firm. The global market also brought the financial institutions in contact with European and Asian investors searching for an alternative investment product. The first realization for these firms was that they already had the basic tenets of the product — their proprietary desks. The second realization was that they could end the brain drain problem at the same time. The result of these realizations was the formation of internal hedge funds within the infrastructure and framework of an institutional setting. Hedge funds were being dressed up.

It's not as if the financial institutions did not see this transformation occurring. Their prime brokerage units had already laid the groundwork for the evolution of the hedge fund industry. In fact, the prime brokerage units were arguably some of the most profitable groups in the financial services industry. The trend for prime brokers to be instrumental in raising money for their clients will be one of the distinguishing factors in the years ahead. The synergies that result are strikingly obvious. However, for major financial institutions to match their investing clients with their prime brokerage clients, a due diligence protocol would be necessary.

Obviously, performance criteria would be the initial distinction. However, institutional clients or prestigious high net worth clients of financial institutions also expect the appropriate levels of risk management and internal controls to be implicit in organizations with which they invest. Simultaneously with this were the various regulatory studies being released as the result of the events of LTCM. The Basle Committee released in January 1999 its report on sound practices for banks in their interactions with highly leveraged institutions. Then in April 1999 the report on the President's Working Group on Financial Markets (authored by the Department of the Treasury, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and the Commodity Futures Trading Commission) was released discussing "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management". Most recently, the Counterparty Risk Management Policy Group, composed of 12 of the major financial banking and investment banking institutions, released its report in June of 1999 on "Improving Counterparty Risk Management Practices". When these reports are read in conjunction with "Risk Standards for Institutional Investment Managers and Institutional Investors", released in 1996 by the Risk Standards Working Group, it begins to create a possible framework of what the sophisticated educated investor wants to see in any asset management organization, including hedge funds. The qualitative aspects that emerge include risk management and oversight, credit and collateral risk, organizational structure, internal controls, valuation policies, management reporting, investor relations and technology and information systems. Asset allocators, counterparty lenders and fund of funds all began to request similar information from hedge funds over the past few years as part of their due diligence process.

Hedge funds by their nature are very resilient and adaptable organizations. While maintaining the confidentiality and private nature of their firms, many of the more established hedge funds had been quietly building high quality organizations with very sound internal control and risk management practices. In fact, it might be difficult to distinguish these organizations from many of their sophisticated asset management counterparts. So, responding to many of the new requests was fairly straightforward. Some of the smaller hedge fund organizations were actually utilizing much of the technology (and, in some cases, risk management software) of the prime brokers integral to the structuring of their organization. While many of the attractions of the hedge fund world still remained (availability of technology, ease of entry, geographical mobility, fee structure), the independence from the red tape of large institutions was diminishing. What goes around, comes around and the hedge fund world began adapting to dealing with this constituency. The perception of low value added from the mutual fund industry continued to drive the institutional investor toward the hedge fund world. However, the slow change from a supply side equation to a demand driven industry was clearly emerging.

Hedge funds also began redefining their organizations by diversifying across product type. Rather than losing investors seeking diversification or different investment styles, hedge funds began offering a family of products that began to resemble strategies employed by the mutual funds during their evolution. At the same time they maintained their edge and their differentiation from the traditional asset management world by trading all global markets, utilizing a wider range of financial instruments and derivatives, employing more complex trading and hedging strategies and utilizing various degrees of leverage to achieve absolute returns. So while the trading styles become more disparate relative to mutual funds, the marketing, distribution mechanisms and information channels of hedge funds draw it closer to that sector as it begins to mature. We have even seen the emergence of hedge funds within a mutual fund regulatory format as a means of offering the value added trading function to the retail investor. Or, everything new is old again.

If the institutionalization of hedge funds hadn't had enough momentum, along came the IPO. Several public asset management companies designed to purchase and consolidate smaller investment management companies began offering hedge fund organizations an opportunity to participate in the public markets and securitize the cash flow from their investment contracts. As hedge fund organizations mature and begin to pass from the founding members, this becomes more of a reality for many of these firms.

The hedge fund world will continue to change rapidly, in large part due to the evolution and demographic changes occurring in asset management. But it will also change because of its resiliency and the tremendous legions of talent embedded in the industry. The change to the attraction of capital from institutional and sophisticated investors, the creation of internal hedge funds, the securitization of the franchise value of hedge funds and the focus on distribution channels and branding are altering the hedge fund world. Will it continue to institutionalize at the same pace? It appears to have the fundamental advantages to propel its advance and challenge the traditional asset management and mutual fund world for a place at the institutional investor table. Or as one poet once sang

As the present now will later be past, the order is rapidly fadin'.

Contact Details:

John M. Budzyna

Tel: +1 212 708 4557

Email: john.m.budzyna@us.arthurandersen.com