Pressures to Adapt in Ernst & Young Hedge Fund Survey

From Ernst & Young

This is the Executive Summary of the 2016 Global Hedge Fund and Investor Survey

ey-logo-tallShrinking returns and escalating investor demands. Downward pressure on fees and unrelenting requirements to have robust operating models. This year, competing forces came together to culminate in the perfect storm. In a year marked by lackluster performance and rising investor expectations, one inevitably asks: Will the challenges of today pave the way to a more successful tomorrow? That all depends on how you respond. As we look back on the year that has passed and look ahead to 2017, a few points come into sharp focus. Differentiation has become the touchstone of the future, and those funds that strategically embrace change for the right reasons and modify their business model in a way that responds to investor demands will be the ones that prosper going forward. Today, the pace of change is accelerating, and the magnitude of its impact and relevance are amplifying. As you turn the pages of this, our 10th annual Global Hedge Fund and Investor Survey, Will adapting to today’s evolving demands help you stand out tomorrow?, we hope the observations that have been gleaned help contribute to an ongoing and healthy dialogue that promotes the continued development and advancement of the global hedge fund industry.

First, we would like to extend sincere thanks to those managers and investors who provided viewpoints into the direction and development of this survey, as well as express appreciation to the 100 managers and more than 60 investors who gave their time and insight to provide such robust results. We believe that this combination of perspectives provides invaluable observations — both commonalities and differences — that continue to drive and shape our industry.

The change continuum
It is important to note that many of the key themes that we are talking about this year are those that have
developed over the course of many years, and are now being thrust to the forefront as external pressures and
competition for capital mount. The directive for managers has never been clearer: adapt or be left behind.

Key observations

This year, our survey focused on a variety of interesting themes, a few of which are briefly highlighted here.

The voice of the investor — 2016 has revealed an unprecedented change in the appetite of investors. More so than ever, investors have achieved a level of sophistication that is challenging managers to more thoroughly explain how their offering achieves specific objectives within investors’ overall portfolios. Almost half of investors are continuing to actively seek out non-traditional products, and when it comes to investing in hedge funds, their choice is segregated accounts that generally allow for customization that more closely align with their specific needs. In addition, investors are demanding more and paying less. Many investors who have utilized low-cost, passive investment options or those who have reduced their reliance on money managers altogether and are trading on their own behalf are challenging the fee terms of their funds. And while management fees have continued to come down across funds of all sizes, investors are not materially any more satisfied with the fees they are paying relative to past
years. Pressure on fees is not likely to let up, which begs the question: How do fund managers achieve scale to
maintain profitability?

Differing priorities for different size managers — Although growth continues to be a priority for funds of
all sizes, the smallest managers in particular view growth as an imperative to offset lost fee revenues, as well as
mounting expenditures necessary to run the business. The largest managers are most able to weather industry
volatility and uncertainty; having largely achieved their growth targets, they increasingly focus on properly
supporting their business from an infrastructure and operating model perspective. Meanwhile, midsize managers are placing their bets on talent management, recognizing that their growth agenda and ability to compete with the largest managers can be served by attracting and developing the best and brightest talent.

The path to growth is changing — With asset flows stagnating and investors changing the way they invest,
managers are facing the imperative to differentiate not only from one another, but from the growing number of
alternative products that are available. We found that in this challenging fundraising environment, managers,
particularly midsize and smaller, are emphasizing existing products rather than developing new ones. Amidst a
crowded playing field, innovation and responsiveness to customer needs are imperative to standing out. Next generational data analysis is just one example of the methods that certain managers are deploying to enhance their investment strategy and appeal to investors. Additionally, those managers who identify and thoughtfully target the needs of specific client segments are finding themselves best aligned for success.

Large managers are out in front — The over $10b assets under management managers have the upper hand in
today’s landscape for a variety of reasons. They have been most successful at raising capital, and have also been more responsive to changing investor demands — offering both the customization and nontraditional hedge fund products investors are looking for, along with the marketing, messaging and operational infrastructure that caters to evolving investor tastes. Investor desire to co-develop specific vehicles — those that provide the investor everything from
unique fees to individual transparency and portfolio exposures — falls squarely in the sweet spot of the largest
managers. While just 40% offered funds with customized fees and terms in 2015, 2016 has seen that spike to 63%. Similarly, while only 25% offered funds with customized portfolio exposures in 2015, that has now risen to 41%. In addition, the largest managers have sufficient size and scale to support a broader array of products, and as they add nontraditional products to their offerings, smaller managers that cannot support such launches are retrenching — adding more fuel to the allocation trend toward the largest managers.

The operational imperative — As top-line fee pressures intensify and the costs to run an evolved business model
increase, the quest for profitability grows even more challenging. New products and customization being driven
by investor preferences, while generally being lower fee generating, only add to operational complexities. And
investors have clearly communicated that they will not compromise in their expectations that managers have
robust infrastructures to support their business. However, investors are also vocal about their desire to not bear the
costs of such enhancements. Inevitably, managers are responding by aggressively refining their infrastructure to
eliminate redundancies and excessive costs, as well as cutting management fees. Investments in technology, including using robotics, are leading to improved automation, and cost reductions across big-ticket support
functions in the middle and back office are contributing to declining operating expense ratios, which most managers
believe have hit bottom. Conversely, nearly half of investors feel there is still more room to cut. Outsourcing
is another way that managers will achieve further operational efficiencies and cost reduction, although
there is still a major divide between the high comfort level that investors feel toward outsourcing compared with
managers’ reluctance to relinquish control.

The changing prime brokerage industry — In last year’s survey, we saw the evolving dynamics of the prime
brokerage industry take center stage, and this year is no exception. As banks face continued scrutiny and
regulatory pressure, managers and their counterparties continue to grapple with the focus on optimization,
funding, balance sheet and liquidity. As a result, many managers have fundamentally changed their prime
brokerage relationships, entered into new ones, and increased the number of counterparties they do business
with. A majority of managers say that their prime brokers have requested significant alterations to their relationship
to keep it economically viable, including increased trade allocations, treasury optimization and platform changes.
As a result, relationship monitoring and supervision has become more complex, and governance around
relationship management has become more imperative than ever — with a need for formalized structures to drive
consistent strategy and oversight of the process. Hedge funds managers are addressing these needs by formalizing
the treasury function and adding headcount to this area of their business.

The war for talent — Talent management rose to the top of hedge fund managers’ and investors’ priorities
this year as the war for talent has taken on additional complexities. Not only are funds battling each other
for tomorrow’s star players, they now find themselves in heated competition with Internet giants and tech
firms, as well as venture capital and start-up companies across all industries. Managers need to demonstrate to
investors that they understand the changing talent market and have implemented programs that will help them
secure and retain the talent that will drive their business forward. As borne out in this year’s survey findings, talent
management now plays a critical role in the competition for institutional assets, with 75% of investors indicating it
is a key element in their due diligence process. The focus on talent is sure to continue evolving, as a divide exists
between what managers consider paramount versus what future generations of employees believe is critical to
attracting them to employers.

Looking forward

As the industry embarks on this next phase in its life cycle, it is clearly fraught with challenges for both managers and
investors. The ground rules have changed, and acceptance and adaptation to this dynamic environment are the keys
to survival. Changing investor demands are driving a myriad of changes and those firms that listen, understand
and strategically embrace change are the firms that will be best positioned to weather the storm. Will adapting to
today’s evolving demands help you stand out tomorrow?

At EY, we remain enthusiastic about the future of the  global hedge fund industry and look forward to continuing to invest in and support its efforts to enhance financial well-being for investors worldwide.


related articles:

Talent, PB Fees, and Middle Office Outsourcing Highlighted in E&Y HF Survey (Nov 2015)

Fee Pressures Are a Hot Button (Aug 2015)

Graphic of the Day – Top Strategic Priorities of Hedge Fund Management Companies (Jan 2014)