Static allocations may foil the growth ambitions of hedge funds
- Growth is the top strategic priority for 67% of hedge funds this year
- Battle to maintain margins, as costs outpace revenues for one in three managers
- Polarity between large and small managers increases
- Investors access funds directly, cutting out funds of funds
Singapore, 10 December 2013 – As the hedge fund industry matures, managers who survived the financial crisis are now beginning to focus on growing beyond their original business models, according to EY’s seventh annual survey of the global hedge fund market, Exploring pathways to growth. However, the survey shows that while managers want to grow their assets under management through new products and distribution channels, investors do not necessarily plan to increase allocations to hedge funds and are not interested in buying multiple products from one manager.
The 2013 global survey compares opinions from 100 hedge fund managers who collectively manage nearly US$850b and 65 institutional investors with over US$190b allocated to hedge funds. Topics covered in the survey include strategic priorities for hedge funds, changes in revenues and costs, technology, headcount, outsourcing and shadowing, and the future of the hedge fund industry.
Art Tully, EY’s Global Hedge Fund Services Co-Leader, says: “Managers are investing heavily to promote growth, expanding into new strategies and products such as institutional long-only offerings and registered funds. They are also devoting more resources to operational infrastructure in order to scale that growth. The largest managers are making the bulk of these investments, and for now they appear to be reaping the rewards, attracting the majority of the industry inflows. But the growth ambitions of managers may not be matched by sustained investor appetite.”
Managers more bullish about growth than investors
Managers are optimistic about their growth prospects. In addition to investing in new strategies and products, managers are developing distribution networks and channels in which they have traditionally not been engaged. However, their optimism is not shared by investors. A majority of investors (72%) say that they expect to maintain current allocation levels, while managers, particularly smaller managers, remain bullish about both inflows and market appreciation – managers with less than US$10b under management are budgeting for 15% growth in 2013.
Michael Serota, EY’s Global Hedge Fund Services Co-Leader, says: “While managers seem determined to diversify their offerings, investors are much less interested in buying multiple products from the same manager. Instead, they seek the best type of manager for particular strategies. This explains why managers attract money from new clients at almost the same rate as they do from existing clients.”
Battle to maintain margins, as cost increases outpace revenue growth
As investor and regulatory demands grow, managers are focusing relentlessly on operational efficiency and costs in the battle to maintain margins.
According to the survey, two in three managers reported an increase in revenues over the past year as performance improved and assets grew. However, just half of managers reported improvements in margins. One in three managers said margins declined and another 10% noted margins remained unchanged as costs increased.
Just one in three European managers noted that costs have increased versus 58% in North America. Although three in four managers in Asia said that costs had increased, they have also been the most successful in raising capital and thereby growing revenue, and margins have improved as a result. Managers in Asia saw 25% growth in capital raised; those in Europe in North America saw growth of 10% and 1% respectively.
In securing growth, Brian Thung, Asean Asset Management Leader at EY observes that managers in the developed Western markets are more focused on developing additional distribution networks while Asian managers are focused on upgrading talent. “Asia has continued to attract overseas talent as well as build talent locally, and Asian fund managers have had to manage a combination of legal, tax and regulatory concerns around the movement of human capital. To that end, fund managers should focus on developing practical solutions with their service providers that are ‘acceptable’ rather than search in vain for the right answer,” he says.
Managers attribute increased costs to developing infrastructure to meet demands of regulatory reporting, upgrading technology and scaling the business to service growing assets. To date, regulations have primarily served to add costs to the system – costs that are being borne by investors and managers, but have provided minimal benefit to the due diligence process or to minimize any concerns of systemic risk. In fact, over two-thirds of investors say that regulations have had no impact on their due diligence process for vetting investments. Investors and managers are more aligned than in the past in their expectations for the future. Both expect increasing regulatory intrusions and accompanying costs.
Thung comments: “Rising costs and regulatory challenges are less of a concern for Asian managers than globally. Break-even levels are lower, and growth is still the single-minded focus of most funds in Singapore. The cost of operating a hedge fund in Asia depends on many factors including the structure that managers start with, the build-out of their platforms, what they develop in-house and outsource, and the consolidation of functions across service providers.”
Additionally, the cost of shadowing is significant. When asked what conditions are needed to reduce shadowing, some managers cited a higher level of integration with their administrators. Others admit that they would need agreement among all their investors that they could stop.
Polarity between large and small managers increases
Increased polarization in the industry is more evident than ever, with the largest funds succeeding because of their size and scale and their ability and willingness to invest in the business, and the smallest by virtue of simplicity. In particular, the largest and smallest managers have the most efficient headcount ratios between front-office and back-office personnel – the largest because they have been able to achieve economies of scale and the smallest because they cannot afford to be inefficient.
“Fewer managers than in 2012 said they plan on adding headcount across front and back office functions – a sign that the pace of hiring is slowing,” says Serota. “However, the largest managers continue to add headcount at a faster rate than the overall market in virtually every function, including marketing, investment operations, risk management and legal/compliance, to ensure their operating models are adequate and scalable to support growth and meet the expectations of investors and consultants.”
North America leads Europe in offering more customized solutions
There is a growing demand for customized solutions, and that demand is clearly being met. Nearly two-thirds of investors either already invest or would like to invest in a customized product. Demand is most evident among funds of funds, with nearly 70% of funds of funds surveyed already invested in a customized solution and another 15% saying they would like to. However, there are some geographical differences, as 75% of managers in North America offer customized solutions or plan to, compared with just 50% of managers in Europe. Asian fund managers, in their pursuit to attract capital, are more flexible in developing customized products with lower minimum commitments.
“Hedge fund managers that can offer the best customized solutions at a competitive price and those that can say ‘no’ will be most successful in the long term,” notes Tully. “Right now, the largest managers appear to be winning – they can offer customized solutions at the lowest marginal cost.”
Shift to direct investment
More than 75% of hedge fund managers in Europe and North America say that direct investment has increased and most expect this trend to continue.
“Direct investment continues to increase and is preferred by managers, with intermediation shifting away from funds of funds to investment consultants,” says Serota. “As such, some funds of funds are offering more advisory-like services in order to compete. With returns likely to remain subdued and investors finding access easier, there will remain a focus on the costs of intermediation.”
An increasing proportion of managers expect that they will work with investment consultants in the coming years, which has meaningful implications for managers’ marketing strategies and service models. Funds of funds are responding by seeking out newer, smaller, managers; seeking greater concessions from them and being able to present smaller institutional investors with a package that is still saleable.
On the future of the industry in Asia, Brian Thung concludes: "The regulators in Singapore and Hong Kong want managers to succeed in their businesses, while abiding by the rules. The atmosphere is welcoming and not hostile, and the infrastructure is designed to help funds succeed."
About the survey
Greenwich Associates, a global research and consulting firm, interviewed 100 hedge funds representing nearly US$850 billion in assets under management, and the views of 65 institutional investors representing over US$715 billion in assets under management, with over US$190 billion allocated to hedge funds. The objective of the study was to record the views and opinions of hedge funds and hedge fund investors globally, measure the views of each on the same topics and examine the two groups together. Hedge funds and investors were asked to comment on strategic priorities, changes in revenues and costs, technology, headcount, outsourcing and shadowing and the future of the hedge fund industry. For the full survey report, please visit www.ey.com/HedgeFundSurvey.
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