New hedge fund launches are smaller and cheaper

Is the hedge fund industry on the path to regaining its former size and power after two challenging years during which its very survival was questioned? Hedge fund advisers and service providers – who often spot trends well before they emerge – say there is a long pipeline of new funds being launched as capital flows back into the industry. GlobeOp, which provides administration services to more than 6 per cent of the global hedge fund industry, says it saw almost no start-ups last year after helping to set up 60-70 funds a year in 2004-06.
“The reason is clear,” says Hans Hufschmid, chief executive of GlobeOp. “From September 2008 onwards subscriptions fell off a cliff. They had been running at $1.5bn [£922m, €1.01bn] to $4bn a month before that. Then they fell to $200m.”
In addition, there was a raft of redemptions. But greater certainty in the capital markets and the recovery of equities has lifted subscriptions to funds that GlobeOp services back to their earlier levels.
The Cayman Islands, where 80 per cent of all hedge funds are domiciled, has seen a strong pick-up in new fund activity. Ingrid Pierce, head of the Cayman Islands hedge fund practice at Walkers, a law firm, says: “We started getting patchy interest in launching new funds in the summer, which has turned into solid instructions for the end of 2009 and the start of 2010.”
The fund activity falls broadly into two camps: restructured versions of funds that had experienced large redemptions and falls in net asset value, or brand new funds seeking to take advantage of inefficiencies thrown up by the credit crisis.
The strategies of the latter group are often highly targeted, says Ms Pierce. “Strategies are often targeted with a specific set of investors in mind. More managers are prepared to send out draft documents to prominent clients and potential clients to determine if a strategy works for them, and then re-define it depending on the feedback received.”
The strategies employed are not the only element that is changing in hedge funds. Fund sizes are smaller, fees structures are mutating, and investors’ liquidity and transparency demands are rising.
Appleby, a Caymans-based legal firm, points out that fund launches are significantly smaller than previous vintages. “$50m is the new $500m,” says Gray Smith, a partner. Part of the invested capital is frequently sourced from the management team itself these days, he adds. “They are injecting their own funds while they get back into the game and establish a track record, so if significant money returns next year they can show the strategy works.”
These smaller funds are often focused on illiquid strategies, perhaps on instruments bought at distressed prices from banks and other financial institutions. “Hedge funds may buy and hold these for between one and three years to extract the value,” says Mr Hufschmid.
Dealing with illiquid investments was one of the big issues of last year, and many new funds have listened well to angry investors who were “gated” – unable to access their funds at the height of the crisis. Many funds with illiquid investments now demand lock-up commitments commensurate with the fund’s strategy. This would be unpalatable to many investors except that the fee model is sometimes advantageous: rather than being payable on a quarterly or annual basis, the fee only falls due when the fund liquidates the asset, much like a private equity investment. Indeed, this structure has been dubbed a “hybrid fund” because of its strong resemblance to a private equity vehicle.
Other innovative fee structures are also in evidence. Start-up hedge fund Northlight has pledged that half of its annual performance fees will be reinvested into the fund alongside client money and will remain locked in until the clients withdraw their own capital. The fund will also charge fees on a “1.5 and 15” basis - below the “2 and 20” industry standard.
However, industry participants do not believe fees are under pressure across the board. “In the long term, fees might fall, but we’ve not really seen that yet,” says Mr Hufschmid. “New funds are more likely to cut deals though, or give up part of the management company to attract capital.”
Fees are less of an issue than transparency in the post-Madoff era. Mr Hufschmid says: “In the past, transparency centred on a desire to monitor a manager’s positions to check there is no style drift. Now it is foremost about ensuring that the assets and the cash are actually there.”
Investors also want to know who the prime brokers are, the creditworthiness of each and the exposure to each.
The practice of rehypothecation (investing collateral to produce a higher return), which was prevalent before the collapse of Lehman Brothers, is now much less common.
Any new hedge fund must be able to provide ample information on their service providers too, given that any collusion between the fund manager and the independent calculation of the net asset value could be disastrous for investors. A simple focus on quality is also at the heart of this.
These extra layers of investor protection have been inserted without the need for formal regulation, which is good news for an industry often criticised for not acting in concert. But will it mean a return to its halcyon days when service providers struggled to meet demand for new launches? Mr Hufschmid is doubtful: “I don’t think we’ll get back to 2005 – but then there was an unusually high level of new funds.”