Solomon Harris partner Richard Addlestone shares his views of the state of the alternative investment fund industry and current trends.
Challenging market conditions and a preference by institutional investors for capital preservation, rather than a risk-on approach, have meant that general hedge fund performance and returns were still largely poor in comparison to pre-financial crisis returns, says Addlestone.
While some fund managers kept a strong track record and produced double digit returns, unpredictable and volatile markets in 2012 still saw fund performance average below that of the S&P 500. According to Hedge Fund Research, the average equity long/short fund was up 7.4 per cent in 2012 and adding 5.5 per cent in the first quarter of 2013.
“Distressed debt funds in Europe have not done as well as anticipated, for example, but that tide may be turning now as banks are forced to shift troubled assets off their balance sheets,” he says.
Despite the weak performance and talk of investors losing faith in funds, there has been no material outflow of capital. Industry assets were reported to have increased every month for the last six months and net positive investor inflows stood at US$500 million in April 2013.
Addlestone says, global mutual funds are adapting their strategies in an attempt to appeal to investors concerned with asset preservation.
Pension funds are looking to longer strategies and increasingly illiquid assets such as property and infrastructure.
Although high mainstream asset values offer poor yields and fuel fears of overvaluation, strategies such as low cost and low volatility advanced beta investments funds have seen global asset growth, he says.
There has also been a recent significant shift from credit strategies into equities as managers diversify.
According to Hedge Fund Research, net withdrawals by investors from equity funds in 2012 were US$106bn but in Q1 2013, there was net investment in equity funds of US$1.2bn.
In contrast to the general consensus that emerging markets were an opportunity, more recently there has been concern over the economic slowdown in Brazil and China.
Fund managers are seeking developed market opportunities again, as Chinese, Indian and Brazilian companies are regarded as expensive and because of questions over the ability of emerging markets to realise value in a reasonable period, Addlestone says.
“Although there has been a retreat from emerging markets, whether this continues long term will depend on developed market factors such as a US recovery, of which there are embryonic signs, or more US quantitative easing, which seems less likely given the recent announcement of tapering by the Fed.”
Meanwhile, legal and regulatory developments over the last 12 to 18 months are going to represent their own challenges for fund managers, says Addlestone, who also notes an element of regulatory fatigue affecting the industry.
Meeting the disclosure requirements of each new individual US and EU regulation will inevitably add to set up and running costs, he says.
Managers will have to redesign and then maintain their compliance procedures and information gathering systems, to identify US persons for the Foreign Account Tax Compliance Act, provide information on assets, liquidity and strategy for Dodd Frank’s Form PF or to meet new rules on the management and marketing of funds for the Alternative Investment Fund Manager’s Directive which is due to come into force on 22 July, 2013.
Once these regulations settle, the bigger challenge will be to rationalise those systems and procedures and reduce those costs, he says.
Aside from the internal challenges regulatory initiatives also have an impact on the markets.
The “Volcker rule” has generated new entrants to the market as teams spin out from the investment banks. And the effect of the AIFMD and lack of certainty over the application of its complex rules may divide markets as some managers turn their backs on Europe and turn their attention to investors in Asia and the Middle East.
This would have the effect of restricting choices for investors. Some managers are taking a “wait and see” approach.
However, Addlestone says, others could take the plunge to set up an EU base, if they do not already have one, and go for full compliance with AIFMD to be sure of accessing the EU wide marketing passport immediately.
The EU wide marketing passport will not be available until 2015 for non-EU based managers. Non-EU based managers will have to rely on private placement rules in the interim which itself requires partial compliance with AIFMD, including enhanced reporting requirements.
This could stimulate a demand for the establishment of an EU and/or non EU “rent-an-AIFM” concept that is a possible new offering for service providers to those managers who would rather outsource compliance requirements under AIFMD.
Manager investor relationship
New regulations mean fund managers will have to commit material resources to their internal governance and risk management processes.
The AIFMD alone will require fund managers to assess and report to investors and regulators on exposure, leverage, liquidity and risk management systems. And having spent time and money lobbying to dilute new regulations, fund managers need to convince investors that their interests are aligned with those of their clients and that they take these issues seriously.
Most managers recognise the changes in investors’ priorities, and the importance of an independent board whose directors offer a mix of skills, including legal, administration, audit and asset management.
But fund managers are also finding their hands tied by increasingly risk-averse investors, particularly institutions, who are concentrating on capital preservation.
Recent high profile frauds, such as Madoff, and concerted industry lobbying against regulations which are designed to protect investors have hit investors’ trust in fund management.
It has made them more aware of the value of effective due diligence and having independent directors to fight their corner, oversee robust corporate governance standards and provide independent and accountable oversight.
In some cases the value placed on having a majority of independent directors, or even a totally independent board, has stretched to investors insisting that the independent directors come from different independent directorship firms.
Further, investors are now focusing on particular skill sets and looking for the right mix of skills on the board. Given that fund raising is still difficult for start-up and midsize managers who need seed capital, seed investors have the upper hand in negotiating preferential terms.