Hedge Funds Adapt to a New Reality

Hedge funds have weathered the storm of the financial crisis, but they must now compete in a much tougher marketplace. Legislators are preparing tighter regulation while investors are closely vetting every position they take. In order to thrive in this climate, hedge fund managers must change how they interact with stakeholders and how they manage risk and operations. The industry has already initiated major changes that are likely to continue, but the endgame is not yet in sight.

Toward Independent Validation

The credit crisis brought one significant benefit to the hedge fund industry: it crystallised shortcomings that were overlooked during the boom years and demonstrated the need for better governance, risk management and transparency. In recent months, funds have responded with greater transparency, better clarity about valuations and the valuation process, and improved fund governance.

In order to entice new capital in today's environment, many funds have changed their fee structures and improved investor communications, according to a recent Ernst & Young survey of hedge fund executives. Managers are also resigning themselves to the inevitable wave of new regulations and increased scrutiny from investors in preparation, so they have begun enhancing their risk governance and compliance processes.

For example, some hedge funds have instituted boards that are closely involved in a firm's decisions that significantly impact investors. They seem well aware that only true independence and regular involvement will ensure that boards are successful.

Investors have also been pushing for more independence in valuations. The survey shows there is a wide divergence of opinions when it comes to third-party valuation of portfolios.

While investors have expressed a desire for more use of independent firms, many hedge funds remain sceptical of their abilities, especially when it comes to valuing illiquid assets. In fact, 30% of respondents to the survey said it was unrealistic to expect third-party firms to properly value illiquid assets.

Improving Transparency

It is little surprise that transparency has been one of the focal points over the past year. This trend has largely been driven by investors, who have become more sophisticated and involved in the wake of the crisis. Fund managers say they are fielding more questions from investors than ever before and although this dialogue can be costly and time-consuming, it is leading to stronger relationships.

Some hedge funds now share a wide swath of data with their investors, ranging from leverage details to geographic distribution. Investors mainly seem to be seeking two levels of transparency.

They desire third-party confirmation of a firm's financial standing. They also are requesting regular reports that detail a fund's basic financials such as net asset value and long-short exposure. When it comes to P&L data and information on individual investments, however, investors may be satisfied with information provided directly by the fund manager as long as the data is independently verified.

Updating Risk Management

Fund managers have shown an increased emphasis on risk management. Almost 40% of survey respondents said that they either already have or expect to make changes to their risk management frameworks. For investors, custody has been one of the most central concerns related to risk; during the crisis, they were often unsure that their assets were held safely.

Some hedge fund managers have updated their risk management processes to include establishing custody arrangements with equity prime brokers and using third-party custodians to hold assets for over-the-counter trading. In a clear sign of how risk management can sometimes trump performance, some managers are putting excess cash into custody instead of into yield-enhancing investments.

Preparing for Regulation

Despite all the voluntary changes that hedge funds are currently making, it has become quite clear that many regulatory changes are soon to come. Legislators have set their sights on the hedge fund industry, and little can be done to escape increased attention. A growing number of managers now expect they will have to register with the Securities and Exchange Commission.

Managers considering registration might seek professional advice, however, because registration requirements are proving to be onerous.

The most important regulatory challenge, however, seems to stem from the European Union's Draft Directive on Alternative Investment Fund Managers, which could have a dramatic effect on hedge fund flows and even hamper the ability of international funds to do business in the EU. However, Ernst & Young's survey shows that too few managers are educated about the directive: 30% of the managers in Europe, 47% of managers in the US and 60% in Asia said they are not familiar with it.

One significant difficulty in regulating hedge funds is a lack of understanding from the investing public. Some legislative reform efforts have been based upon "common sense" approaches, which appeal to voters but can be based on faulty reasoning. Most of these approaches do little to improve transparency or risk management practices and often cost investors by imposing unnecessary regulatory requirements.

In fact, most managers surveyed by Ernst & Young believed that changes in response to investor demands are more productive and less costly than regulations imposed by government.

In order to ensure that regulations are sensible and beneficial, hedge fund advocates such as the Managed Funds Association are now working on educating both legislators and the public.

Assessing Tax Changes

Hedge funds will also have to deal with a more hostile tax climate. Congress is likely to raise taxes and although it is not clear yet how that burden will be distributed, survey participants said that it is likely some of it will fall on alternative asset managers and their investors.

One of the most significant tax changes is the Foreign Account Tax Compliance Act, which would give the US Treasury more power to investigate and potentially prosecute US citizens who hide foreign assets from the Internal Revenue Service (IRS). If passed, such a law could require fund managers to sharply increase the scope of investor data they must report. Surprisingly, despite much discussion about the redomiciling of fund operations to avoid higher US taxes, few managers plan to actually move their businesses, according to the survey.

At the behest of Congress, the IRS has also established a separate audit group responsible for looking into tax compliance by hedge funds and high-net-worth individuals. So far, the group has shown an aggressive inspection pattern, requesting historic emails, auditing voicemail records and not showing much flexibility in scaling down the depth or breadth of their requests. Managers under audit said the process is time-consuming and expensive, and often has a chilling effect on investors.

Continuing to Transform

Hedge funds experienced a difficult stretch during the financial crisis and many challenges remain ahead. Regulators have set their sights on the industry and taxes are set to rise. Investors are more sceptical, which has sharply raised service expectations and intensified competition.

However, the tide is turning. Investor capital is flowing again and returns are normalising. Despite challenges, the industry remains strong and vibrant. In order to take advantage of the recovery, hedge funds must continue on the long path of transformation.

Arthur Tully is partner and co-leader of the Global Hedge Fund practice in the Financial Services Office of Ernst & Young LLP, New York.

This article first appeared in AIMA Journal (Pg 17, Q2 2010 issue). For more information, please go to