By Charles Gubert, Editor of COOConnect
Here is our take on what happened in 2012, and the clues we picked up as to what hedge fund COOs can look forward to over the next 12 months. In the spirit of the season, and to make it a bit harder for ourselves, we decided to restrict ourselves to headlines beginning with the letter `p.’ As you can see, we found it a bit of stretch at times.
Throughout 2012, managers and investors were united in their view that hedge funds could not afford another year of under-performance, and that some combination of fee reductions and redemptions would strike any fund that failed to add value. As it happens, the average hedge fund has had an okay year, despite operating in markets driven by nothing but inevitably arbitrary political decisions. As of December 7 2012, the HFRI Fund Weighted Composite Index was up 4.89%, which is a considerable improvement on the 5% decline recorded by the same index this time last year. But averages conceal wide variations. The weakest strategy in 2011 – equity long/short – rebounded and generated solid gains of 5.77%, much to the surprise of industry pessimists. Macro, flat at best in 2011, declined 0.93% in the most obvious tribute to the scary thought processes of central bankers and politicians in 2012. Emerging markets, benefiting in part from investments fleeing the zombie economies of Western Europe and North America were all up in 2012, despite mid-year dips in many countries. A recent survey by Aksia predicts emerging market strategies will post double digit returns in 2013. Relative value strategies were the best-performing asset class in 2012 with the HFRI Relative Value Index up 9.54%. Funds of funds appear to be shaking off their unimpressive track record, with the HFRI Funds of Funds Composite Index up 3.56%. Significant asset flows are reportedly moving towards fixed income, with some speculating the strategy could overtake equity long/short in terms of AuM. So if 2012 was an unremarkable year by the historical standards of the industry, and some funds have not survived it at all, the direst predictions were not borne out by events. This unstable and uncertain macro environment is likely to play out through 2013, and beyond.
For much of 2012, the US presidential election was the most important political decision awaited by managers. Disillusion with President Obama was palpable in the hedge fund industry (his share of hedge fund campaign contributions shrank from 67% in 2008 to 27% in 2012) and hopes were high that a President Romney would repeal Dodd-Frank and make the tax system less hostile. “The mood on the train to work was fraught with angst,” recalled one New York-based investment professional as news of the re-election reached north eastern commuters last month. One predictable consequence is that mandatory clearing, as required by Dodd-Frank, will start in 2013. It is not hard to see why many wanted to duck the challenges that will set: sourcing collateral, managing collateral, risk-managing potential CCP defaults, and negotiating multiple clearing agreements. Yet, in retrospect, the feasibility of anyone repealing a vast piece of legislation such as Dodd Frank was always questionable. “We have had hundreds of guys at the bank working on how we can comply with Dodd-Frank,” said one prime broker even before Obama was re-elected. “If the bill was scrapped, they would put their head in their hands in frustration and go home.” If that fearful hope was extinguished, the importance of political uncertainty to markets has not gone away. The prospect of the US falling off the fiscal cliff is a reminder that current markets are still all about politics, not economics. It is hard to see that changing in 2013. In fact, the US fiscal cliff is now the biggest concern for fund managers, according to a survey by Bank of America Merrill Lynch, which found 54% of managers see it as their biggest tail risk. If bi-partisan politics fixes it, look forward to a burst of enthusiasm in the market. If it does not, it will be better to be short than long. Given the political divisions, one would be better advised to adopt the latter approach.
The first Form PF filing, applicable at end-August to managers running more than $5 billion in “Regulatory AuM” went relatively smoothly. The second batch of submissions, aimed at managers running between $150 million and $1.5 billion, is due for submission 60 days after year-end. It is bound to be more of a struggle, thanks to the number and size of the managers involved, and the inevitably limited data management capabilities of many of them. Questions are of course being asked as to whether the SEC and FSOC will ever be able to digest the data, but it is pointless to think that pointlessness ever halted a government initiative. Phase 2 of Form PF could mark a messy start to 2013.
The CFTC announced in February 2012 that managers trading certain derivatives must register as Commodity Pool Operators (CPOs) and become members of the National Futures Association (NFA) by December 31, 2012 (now only days away). Exemptions can be claimed for firms trading a minimal number of derivatives. Funds of funds were given an extended deadline till June 2013 amid concerns they would struggle to obtain data on all of their underlying managers in time to confirm they too met the minimal trading requirements. Most hedge funds acknowledged CFTC and NFA registration had not been that onerous although added fingerprinting senior traders (as is required under NFA rules) was a minor hassle. Ironically, the biggest operational headache next year is likely to be on firms, particularly funds of funds, trying to claim the de minimis trading exemption.
Ponzi-tential in mainland China
The good news is that once the euro does collapse, real investors will re-emerge and start buying assets which are at the right price. Until then, the best opportunity might just lie in that other government-sponsored Ponzi scheme on the other side of the world: China. The Chinese authorities are currently liberalising the local hedge fund industry in what is potentially a vast, new and exciting market for the industry. The Shanghai Municipal Government Financial Services Office (FSO) is consulting with experts on its Qualified Domestic Limited Partner Program (QDLP), a pilot scheme which will allow approved foreign hedge funds to raise Renminbi-denominated funds in mainland China – although the capital raised must be invested in foreign markets. Another intriguing local initiative is the Wenzhou Pilot, which will allow residents of that affluent city to invest in funds based abroad. The exact nature of the rules is unknown. Hong Kong lawyers and service providers working with Chinese authorities on the proposals have been forced to sign strict non-disclosure agreements. As any visit to Belgravia (or an English public school or Oxbridge college) serves to illustrate, mainland China is host to a lot of wealthy investors. In fact, China has just overtaken Japan as the second biggest spender on luxury goods, lying just behind the US. However, accessing their savings via the official reform process is bound to be protracted, since the country still has exchange controls, let alone an over-regulated set of capital markets. One expert view is that it will take a decade for China to develop a fully functioning hedge fund industry. Nonetheless, forward-thinking marketers will want to spend some time considering recruiting Chinese investors in 2013.
FATCA was delayed until 2014, ostensibly to give foreign financial institutions (FFIs) more time to conduct due diligence on underlying clients and establish systems and technology to facilitate the collection and collation of the data. Another explanation is that finalising intergovernmental agreements (IGAs), which are being negotiated with more than 50 countries, has taken longer than US authorities anticipated. IGAs enable cooperating third countries to receive data on their own recalcitrant account-holders in US financial institutions, although some still predict this carrot will be one-way traffic in favour of the US. As if this was not complex enough, there are three different IGA structures circulating. Managers operating out of multiple jurisdictions, which have signed different IGAs with the US, will have to be compliant with each one. This will undoubtedly increase costs in 2013 (and risks in 2014).
Public (Joe) as hedge fund investor
Buried inside the JOBS Act, a well-meaning piece of legislation aimed at enabling small businesses to raise capital more easily, is a clause scrapping the historic ban on hedge funds advertising and marketing. Supporters of the legislation argue hedge funds are more likely to make public information about their businesses, and that this will be of help to investors as well as regulators. A likelier outcome is continuation of the status quo, as successful managers feel no need to advertise their products to a broader audience. However, it is possible that managers in a growth phase will buy advertisements in trade publications to attract more money to manage. Needless to say, incumbents are warning that only the less talented will make use of a more liberal regime. The truth is that minimum investment of around $500,000 – $1million put funds well beyond the means of most accredited investors (who are classified as individuals with investable assets of $1 million). Less sophisticated investors tend to prefer mutual fund-style liquidity, which only suits a minority of hedge fund strategies. Managers running illiquid assets or distressed credit strategies are unlikely to appeal to these investors and their liquidity demands. The rules have been delayed amid concerns from mutual funds and investor protection groups, which worry less sophisticated investors could find themselves buying into products they ill-understand. Marketing and advertising liberalisation is a shoe-in for 2013 although don’t expect managers to buy ads at the Superbowl anytime soon.
Private placements and passport plus other EU rules
The custodian banks charged with underwriting investor risk under AIFMD have never fancied the open-ended commitment it entails – now including cash flow as well as safekeeping of all assets owned by investors. Nobody knows if private placements and passports are enough to tempt managers to launch onshore funds, or whether custodian banks will even be there to field lost assets, but the safe assumption is that European regulators are hoping not: they want the hedge fund industry, like the investment banking industry, to get smaller. Nothing illustrates that better than the implementation of the ban on naked short-selling of sovereign debt in November 2012. Sporadic short-selling bans, much like in 2011, were also imposed in several EU countries, often to no avail, in what is further evidence of regulators’ hostility to the industry. The regulator-as-enemy is the one certainty in Europe in 2013, given that the AIFMD Level 2 proposals are still unpublished. The Solvency II directive (which imposes 49% capital requirements on insurers, and possibly pension funds, allocating into hedge funds) is also on the backburner. The rules putting that into effect are unlikely to be implemented before 2015. In respect to AIFMD, European regulators are hell-bent on implementing it on time. Expect a last minute rush for managers and depositaries to make right their compliance obligations. Tit-for-tat short-selling bans will also continue throughout 2013.
Pariahs pay taxes
The European Financial Transaction Tax (FTT) is the crazy idea that refused to die. Fortunately, given the need for unanimity at EU level and the strong opposition of the UK, the Netherlands and Sweden, the tax is unlikely to happen. France, inevitably the principal enthusiast, enacted their own version in August 2012. The 0.2% tax applies to all financial transactions in listed French equities with a market value exceeding €1 billion. Predictably, it led to a surge in synthetics routes round the impost, which created anxieties about whether investment banks or fund managers would be liable for any retrospective taxation of these avoidance schemes. Predictably (again) policymakers in France have warned the tax could be extended to derivatives. But taxes nobody pays should in 2013 remain largely a self-inflicted wound for France, where the government is more adept at creating new problems than facing up to existing ones. Eleven countries including Spain, Portugal and Italy are now implementing or will implement the FTT, and Lithuania looks set to become the 12th. More countries will adopt the tax in what could prove to be yet another operational challenge for COOs.
Patrick Pearson hypothecates pain ahead
The biggest threat to the industry as we know is regulation of the so-called shadow banking industry: crudely speaking, the securities financing and securities lending that are at the heart of how the hedge fund industry works. Paul Tucker, the deputy governor of the Bank of England who recently lost the top job to (the inevitable) Goldman alumnus, made a worryingly explicit speech on this topic in Brussels in the spring of 2012. Patrick Pearson, head of financial markets infrastructure at the European Commission, acknowledged recently that explicit caps on re-hypothecation were being actively discussed in that same city. This could change the economics of the prime brokerage industry not just in 2013, but forever. Regulators are discussing a cap of between 125% and 140% on re-hypothecation, the latter of which is the limit employed by the SEC. Pearson said the decision, if it is made at all, would not be taken lightly. It is likely proposals will be published some time in 2013, and maybe 2014. Nonetheless, any material impact of shadow banking reform is unlikely to be felt by managers or prime brokers for several years.
Pooling NAV crackers
Fund administrators, which have managed for years to fragment as fast as they have consolidated, are also finding mergers an appealing alternative to extinction. AIS sold itself to US Bancorp Fund Services. SS&C Technologies purchased GlobeOp for $920 million. Goldman Sachs Administration Services was sold to State Street AIS for $550 million, enabling the Boston-based custodian to leapfrog Citco and become the biggest hedge fund administrator in the world. Shrinkage and consolidation in the hedge fund industry, the institutionalisation of investment, and the additional risks imposed by regulators are prompting many small administrators to search for the exit. One senior fund administrator predicted this year that just 10 fund administrators would still be standing five years’ hence. Banks needing capital to raise their Basel III ratios will be sellers as well as buyers. Expect more administrators to merge (or fail) in 2013.
Prime brokerage contains multitudes, which shows how hard it is to run an investment bank successfully without some exposure to the industry. But the so-called mini primes – an eclectic group of execution-only and clearing brokers plus variations of either or both models – are proving vulnerable in a market short of transactions and warier of counterparty risk. The eye-catching purchase and sale of 2012 was the Wells Fargo acquisition of Merlin Securities. But the disappearance of mini-primes is unlikely to continue to 2013 – because they have disappeared already.
Padded berths sought
A cottage industry argues that hedge funds need better corporate governance. There is no shortage of the superannuated to put themselves forward to service on hedge fund boards as well-paid directors. Investors who argue that directors already sit on too many boards, and lack investment expertise, will never succeed in countering that huge economic incentive: it is not difficult for a general partner to find lackeys to sit on a board. The real danger for managers is regulators taking charge of “corporate governance” and imposing rules. This is bound to happen eventually, but they are probably too busy for it to happen in 2013. Expect more conference panel discussions on corporate governance in 2013.
This article has been reproduced with the kind permission of the author with a few edits. The whole of the review of the year can be found on http://cooconnect.com